2020 was a rollercoaster year for Indian stock markets. 2021 may not be very different

India’s stock markets went through extreme volatility in 2020.

In March, when the markets witnessed their worst-ever sell-off, very few could have predicted that Indian equities would soar to all-time highs by the end of the year. While the Indian economy has entered into a technical recession and the outlook for this financial year is bleak, markets are rallying at a scorching pace. The stringent lockdown in India, which severely dented the economy, seems to be a distant memory for some investors, but the upcoming year could be a struggle.

The extreme pessimism has given way to some optimism for an economic recovery and the disbursement of a vaccine to halt the spread of Covid-19. The benchmark indices, the Bombay Stock Exchange’s Sensex and the National Stock Exchange’s Nifty, are scaling new heights each day. This is in tandem with many global markets, which have also staged a remarkable recovery.

But despite the sharp rise, Indian markets are still lagging behind some of their global peers if one looks at the returns delivered since January 1, 2020.

“The Indian market’s performance has been sub-par in comparison to other markets as some developed markets did much better than India, partly because of the larger stimulus provided by central banks,” observes Hemang Jani, head equity strategist at Motilal Oswal Financial Services. US markets, led by tech stocks, have staged a much quicker recovery than Indian equities.

But even if they are underperforming, India’s stock markets will not necessarily soar ahead in 2021. This is mostly because Indian stocks were extremely overvalued even before the spread of Covid-19. A few select financial and consumer stocks, as well as Mukesh Ambani’s Reliance Industries, catapulted Indian markets to an all-time high in January 2020. Then, the markets were rising while economic growth and earnings were stuttering. From March last year, the coronavirus-triggered lockdown and its economic impact could be seen as an excuse for investors to flee markets.

How will markets perform in 2021?

A strong rebound since March 2020 has made India’s stock markets pricey again. For instance, Nifty’s valuations (price-to-earnings ratio) are currently trading above its five-year average.

“Compared to its own history, versus domestic bond yields (as measured by the equity risk premium), as well as against global and emerging market equities, Indian equities are no longer cheap, and only a short distance away from being the most expensive they have ever been,” says Neelkanth Mishra, of Credit Suisse.

The inflow of foreign capital has also propelled the markets to new highs. Nilesh Shetty, a fund manager at Quantum Asset Management, expects this to continue as low global interest rates make emerging markets attractive. “This, coupled with the impending rebound in economic activity, is making investors’ optimistic,” says Shetty.

While all these factors keep investors enthusiastic, companies’ fundamentals need to improve to match their rising valuations. “The key factor that is likely to determine the future movement of the market is earnings growth,” said Shibani Sircar Kurian, head of equity research at Kotak Mahindra Asset Management. “Second-quarter (July-September) earnings were much better than estimated.” For Kurian, sustained earnings delivery is vital for the markets to continue their upward trend.

The supply side of the economy like manufacturing segment and exports has picked up pace, but demand remains dismal. Indian households are still reeling from job losses and pay cuts. If consumer confidence remains low, it will have an adverse impact on companies’ sales and revenue, and in turn, halt the markets’ rally. Meanwhile, the threat of coronavirus is still there. “Intermittent corrections cannot be ruled out as there is a risk of the second wave of Covid-19, and thus sustenance of economic recovery holds the key,” warns Jani.

His words of caution are not misplaced. India’s was one of the worst-performing economies even in the second quarter of the current financial year.

Which markets will shine brighter?

In contrast, China has emerged as a clear outlier. Not only has it apparently recovered from the impact of Covid-19, it is also already posting positive growth. And despite a high base this year, many economists expect the Chinese economy to grow further at an even faster pace next year.

Experts are also betting on European markets to bounce back sharply after missing the rally in 2020. “European markets, after the Brexit resolution and deployment of Covid vaccines, could do better from now on,” said Deepak Jasani, head of retail research at HDFC Securities. “Emerging markets (including China) can also see a rise in indices after underperforming in 2020.” However, the picture is far from rosy. “Key risks to the markets include an early end to easy monetary policy, an extended/recurrent Covid-19 presence across the globe, and a delay in return to global growth,” he added.

Meanwhile, Indian markets have a tougher road ahead. High stock valuations coupled with a slow economic recovery could provide a reality check to investors’ newfound optimism.

This article first appeared on Quartz.