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India stocks’ rapid rally faces this speed bump

Indian office workers walk past the bronze bull outside the Bombay Stock Exchange
Indranil Mukherjee | AFP | Getty Images
Indian office workers walk past the bronze bull outside the Bombay Stock Exchange

India stocks have sped ahead with a more than 23 percent so far this year, but with valuations becoming less compelling, Goldman Sachs sees a potential speed bump from looming share sales.

"With the government's aggressive divestment plans and ongoing corporate equity raisings, we think the demand/supply balance can turn less favorable in the coming months," Goldman said in a note Tuesday.

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The government is targeting divestments of almost $10 billion worth of shares this fiscal year, with some of the stake sales potentially fast-tracked, it noted. In addition, private-sector companies have raised $3.8 billion of fresh equity so far this year, with the trend set to continue, Goldman said, estimating a pipeline of around $3.1 billion of new and secondary offerings already announced for the rest of the year.

"While the divestments will help India achieve the much needed fiscal consolidation and the corporate capital raising improves balance sheets, history suggests excess equity supply is likely to act as an overhang for the markets unless demand catches up," Goldman said.

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The bank's back-of-the-envelope calculations note that inflows from foreign institutional investors have run around $1.9 billion a month for the past six months; if the government divestments and corporate issuance go as planned, the pipeline could be around $3.2 billion in the second half of the year.

"Estimated supply could dominate demand for equities," it said, noting that it could be underestimating supply and overestimating demand as some of the inflows were on political newsflow related to the election.

The new equity supply comes as valuations are already looking less appealing, Goldman said, noting that on an equal-weighted basis, the MSCI India is trading at 20.5 times forward earnings, the highest in Asia.

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"The risk-reward at current prices thus looks less attractive for many stocks now and we see limited room for further valuation expansion," it said. "This partly explains why investors are finding it harder to find attractive valued stocks with good growth stories."

Goldman expects markets to focus on the new government's execution of reforms and policy in coming months, as well as whether companies deliver on earnings.

Others don't expect it to matter whether the government manages to deliver on the reform agenda.

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The Indian market has been driven by improving risk appetite globally as well as a bottoming out of growth, and not just the change in government," Credit Suisse said in a note Tuesday.

While the MSCI India index's valuation premium to other emerging markets is near a five-year high, the subcontinent's market is better compared with the MSCI World index, where the premium is just a "blip," Credit Suisse said.

Other emerging markets, including China, are likely to have a significantly more tepid recoveries compared with India, it said.

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"Even if the pace of change driven by the new government disappoints consensus (as we expect), the market should still do well," Credit Suisse said.

To be sure, despite citing equity supply concerns, Goldman remains "strategically positive" on India equities, setting a 12-month Nifty index target of 8600, compared with the current level around 7788.

"We are already seeing early signs of an economic recovery and believe corporate earnings recovery will follow soon," Goldman said.

—By CNBC.Com's Leslie Shaffer; Follow her on Twitter @LeslieShaffer1