Easy re-rating phase behind us but valuation froth gone: Devarsh Vakil

With markets navigating a prolonged consolidation phase, valuations have finally cooled even as the easy re-rating cycle draws to a close. Devarsh Vakil underscores that the next leg of the market will be driven less by multiples and more by earnings traction, with early signs of revival already visible. For investors, discipline and selectivity will be critical in this evolving landscape.

Edited excerpts from a chat:

The market remains stuck in a consolidation mode as we approach the last month of 2025. When do you think the tide will start turning and how has the outlook changed after the Q2 earnings season?The broader markets are in a consolidation phase, reflecting lacklustre earnings growth. Prices are a slave to earnings. We expect earnings growth to pick up substantially in FY27, with early signs likely to emerge in the second half of FY26. Once earnings growth accelerates—and markets typically sense this shift a few months in advance—we should see renewed buoyancy in stock prices.Despite external headwinds, India’s domestic growth momentum remains resilient, with FY26 projections little better than FY25 and outlook for FY27 even more robust.

Double-digit FY27 earnings growth could deliver strong market returns, with mid- and small-cap stocks gradually improving. Current weakness offers long-term investors opportunities to accumulate quality stocks at attractive valuations, potentially yielding better returns in the medium to long term.Indian IT stocks are being seen as AI losers. Do you think that can be an advantage whenever the tide turns against AI stocks?Indian IT stocks are currently viewed as “AI laggards,” primarily because of their relatively modest engagement with artificial intelligence and generative AI technologies compared to global peers. Technology giants in the US, China, South Korea, and Taiwan are capitalising on the AI boom through deep tech investments and product innovation. At the same time, Indian firms have so far remained focused on traditional outsourcing, enterprise IT, and cost-efficient service delivery models. Indian IT companies, with their diversified service portfolios and strong client relationships, are steadily integrating AI tools into their delivery and consulting frameworks.

Indian IT stocks may not be front-runners in the ongoing AI rally, but that is offering patient investors an opportunity to accumulate quality technology exposure at reasonable prices.

Which themes are you most bullish on for the next 12-18 months?Our preferred sector for the next 12-18 months is banking and financials.

Banking sector results were better than expectations, as cost of funds declined faster supporting strong NIMs.

Credit momentum also picked up with loan growth of 11% (vs. ~10% in 1Q). Lower interest rates led to softer deposit growth of 10%, as banks deliberately moderated high-cost deposit accretion.

Business growth showed signs of recovery, with large private banks posting robust loan growth, resulting in a higher CD ratio for most of them.

Asset quality performance remained resilient, with improving gross/net slippages across most banks. Credit costs declined to 0.6% (vs. 1.0% in 1Q) and are expected to stay moderate for the remainder of FY26. Fresh slippages improved for most banks but remained elevated for some mid-size banks due to residual stress in unsecured personal and business loans.

Several banks have guided for further NIM improvement in 2HFY26, driven by benefits of CRR cut, continued deposit re-pricing and pickup in loan growth.

In the last 3 months ever since GST reform was first announced, auto stocks have been the biggest winner. Do you think the auto rally has just begun as we are coming from a low cyclical phase?The recent GST rate rationalisation has coincided with a cyclical upturn in the automotive sector, suggesting a structural demand upcycle rather than a one-time boost. The GST rate rationalisation has acted as a catalyst, improving affordability and dealer sentiment at a time when replacement demand was already recovering. We’re also seeing early signs of rural demand revival and easing financing conditions, which should support volume growth across segments.

The auto industry was in a slowdown phase before the reforms, so the current surge is also seen as a cyclical recovery that can be sustained with improved consumer sentiment and easier access to credit.

The GST rate cut has not only improved affordability, especially at the low end of the spectrum, but it has also prompted consumers to shift from two-wheelers to low-end four-wheelers. This has led to a significant influx of first-time car owners at the dealer’s desk, potentially driving a sharp jump in volumes. Further, the new GST regime simplifies the tax structure, eliminates classification disputes, and improves supply chain efficiency, which should lead to better margins for manufacturers in the long run.

What do you think has been the impact of GST rate cuts if we go beyond the auto industry and the seasonal festive demand? And what’s the outlook on consumer stocks for 2026?Beyond autos, the GST rate cuts have broad-based implications. They’ve enhanced sentiment across discretionary categories — from durables to quick-service restaurants. In many cases, it’s not just the lower tax rate but also the perception of policy stability and a consumption-friendly intent that have lifted confidence.

We expect the consumer sector to stage a gradual recovery in H2FY26 as companies report positive offtake in November after the continued transitional impact of the new GST regime in October. A strong run-up to the wedding season, bumper harvest from a good monsoon, benign inflation and a favourable monetary policy environment remain key drivers.

Moreover, as commodity prices cool off and inflation moderates on the back of favourable monsoon, we also expect margins for consumer companies to improve late in H2FY26.

In the broader market, there has been higher optimism for midcaps rather than smallcaps in the last few months. Do you think 2026 could be better for smallcaps?Liquidity is like mother’s milk to bull markets, especially for small stocks. Tight liquidity leads to sub-optimal nominal GDP growth and poor earnings growth from smaller companies.

The RBI has adopted an accommodative stance with cumulative 1% rate cuts in 2025 and a steep CRR reduction, injecting over ₹5.6 lakh crore into the banking system. This has eased funding conditions and improved credit transmission.

Income tax reforms—raising exemptions to ₹12 lakh under the new regime—have boosted middle-class disposable incomes, stimulating consumption and investment flows.

GST rationalisation from four slabs to two (5% and 18%) has reduced indirect tax friction, supporting demand revival across FMCG, automobiles, and discretionary sectors. These measures collectively create a powerful fiscal impulse.

The past six months proved painful, with FIIs selling over $15 billion and triggering sharp corrections in mid and small-cap stocks. Expensive valuations in select pockets, weak earnings growth, and geopolitical uncertainty around tariffs drove the selloff.

Mid and small-cap stocks, trading at high valuations barring a few sectors, underperformed significantly. However, valuations have now become reasonable following price and time corrections, though selectivity remains crucial given the nature of this universe.

Countering FII outflows, DII support has provided critical stability, with India’s expanded domestic investor base now acting as a strong counterweight to foreign outflows.

We expect smaller stocks to start attracting investments, as benchmark indices move towards new all-time highs in the last quarter of FY26 and in the first half of FY27.

How comfortable are you on valuations – are we likely to see a structural re-rating of Indian equities?Earnings growth has not meaningfully picked up across the board so far in H1FY26. While we have seen early signs of revival in earnings growth, only a meaningful revival will result in a structural re-rating of Indian equities. Currently, Nifty trades at ~20x FY27E, India’s premium may persist, but investors will need to be more discerning as the easy re-rating phase is essentially behind us.

Following an extended consolidation phase in Indian equities, especially in mid- and small-caps, the valuation froth we had seen in the past couple of years seems to have come off.

The earnings cycle is seen bottoming out, with growth expected to accelerate into double digits. Over the medium term, we’re more likely to see an earnings-led rather than multiple-led market.

The valuation differential relative to global peers has moderated, which may prompt a return of foreign investors to the Indian market in calendar year 2026.