2025 made markets real again. Does overvaluation mean more trouble ahead?

2025 made markets real again. Does overvaluation mean more trouble ahead?

In the latest episode of The Wealth Formula with N Mahalakshmi, Kalpen Parekh, Managing Director and CEO of DSP Mutual Fund, takes a step back from the noise to ask a harder question: what if 2025 wasn’t a bad year for markets, but a necessary one? As investors grapple with muted returns, bruised mid- and small-cap portfolios and a sense that something has shifted, Parekh unpacks why this phase feels uncomfortable — and what it may be quietly preparing markets, and investors, for next. This is Part 1 of the edited interview.

How do you describe 2025?

2025 feels real. In contrast, 2022, 2023 and 2024 were someflext what unreal. Investors drifted away from how economies and profit cycles actually work and began extrapolating growth indefinitely. There was more euphoria than fundamentals warranted.

2025 has been a year of consolidation — a reminder of market cycles. Revenue growth had already begun slowing in early 2024, even as corporate margins were peaking. In such phases, profitability growth typically moderates into single digits. Yet markets were pricing earnings at 25 times — a valuation justified only when profit growth expectations are 15–20%.

There is nothing unusual about this. Every three to four years, markets go through consolidation. It is investor behaviour — extrapolating both good and bad times — that causes discomfort. In that sense, markets are simply normalising.

We often ask investors: what if your hero asset class gives zero returns? Do you have gold, silver, global equities or bonds as support? In 2025, disciplined and diversified investors still earned around 15%. Gold and silver delivered, global stocks performed strongly, and bonds held up.

Those who chased past high returns earned poor returns. Those who invested in previously ignored assets earned reasonable ones. That’s how markets tend to rebalance.

So, the key reminder was diversification across asset classes.

Broadly yes — with an important nuance. The foundation of asset allocation is low correlation between assets. Today, correlations are unusually high. Global equities, gold, silver, bonds and even domestic equities have all performed well since the February lows.

That isn’t normal over the medium to long term. There will be phases when diversification also delivers lower-than-average returns. Historically, over 30 years, median returns across markets have been about 12–14%. To earn meaningfully more, investors need to deploy capital when returns are depressed — not when trailing returns are 20%, as they were over the last five years.

You are saying given high correlations today, diversification itself may struggle… Looking specifically at equities — we are above intrinsic value?

Slightly above. Not excessively, because mid- and small-caps have corrected and consolidated for a year. But at the aggregate level, corporate India’s long-term profit growth is about 12%. Current valuations imply 16–18% growth. That’s a disconnect.

When markets price growth well above structural realities, medium- to long-term returns moderate. Investors need to normalise expectations. There are very few pockets offering a meaningful margin of safety today.

But the difference between 12% and 16% compounding is massive. And that 12% assumption itself was formed during a higher inflation era. With inflation now structurally lower, shouldn’t nominal growth expectations also come down?

The 12% figure is a long-term median. There are cycles where profits grow at 16–20% and periods where growth is sub-10%. Over time, it averages out.

We’ve won a significant inflation battle over the last decade. If inflation settles at 4–6% and equities deliver 10–12%, that is a strong outcome. Historically, real returns across global equity markets have been 0–6% above inflation over 25–30 years. Sustained returns beyond that are rare.

The objective, ultimately, is to grow purchasing power. If markets deliver inflation plus 4–5%, that is success. India and the US are among the few markets that have achieved inflation-plus-6% over long periods — which also explains why both markets trade at premium valuations.

So, plainly put, with inflation at 4%, equity returns beyond 10% may be unrealistic?

That’s a fair framework. Inflation could be 4, 5 or 6 — but assuming 10–12% equity returns in such a regime is reasonable. Anything more requires favourable timing and liquidity during market downturns.

Most investors are fully invested most of the time. So if you earn 10–12%, you should be satisfied. At 10%, India would still rank among the highest-returning markets globally.

If debt offers inflation plus 2–3%, isn’t that attractive on a risk-adjusted basis?

The adjustment is not for risk but for volatility. Bonds can give inflation plus 2–3% with low volatility. Equities can deliver inflation plus 5–6% — but with volatility that must be endured and harvested.

If inflation erodes purchasing power, owning companies that benefit from inflation is rational. For investors unable to tolerate volatility, hybrid funds and asset mixes become important.

There’s always a trade-off. Higher returns demand higher volatility. Lower volatility delivers lower returns. Over time, markets correct egos. Every year feels difficult because drawdowns are frequent — 20% declines are routine, 40% declines occur every few years. But over rolling six-year periods, Indian equities have consistently beaten inflation by 4–5%.

Stay invested. If volatility is uncomfortable, blend equities with bonds, gold, silver and global assets. There are many paths to the same destination.

How do you see the current overvaluation play out?

The overvaluation in equities is closer to 15%. At an aggregate level, fair value might be around 16–17 times earnings versus roughly 22 times today. But overvaluation doesn’t mean markets must fall. Markets don’t move by maths alone — behaviour matters.

Markets can remain overvalued or undervalued for extended periods. Earlier in my career, markets were often cheap, but returns were poor. Today, returns are healthy but valuations are uncomfortable.

That trade-off never disappears. Markets don’t optimise for investor comfort — we must adapt to them.