Those who do not learn history are doomed to repeat it – George Santayana
Key takaways:
- Continue SIPs/STPs as timing the market is quite difficult.
- If you have high equity allocation (80% plus), equity allocation should be reduced by booking some long-term capital gains from equity mutual fund. If the market were to correct, this can be redeployed.
- Be more conservative with mid-cap funds and invest more in balanced funds.
Time to be greedy or fearful?
The continuous rise in stock market has been good for me. I was not as bearish when demonetization came. In fact, I invested more. Most of my mutual fund investments have delivered 30 to 40% return since then. I did reallocate some money from mid-cap funds to balanced funds but have not redeemed significant amount of money. However, with NIFTY crossing 11000, some of the valuation indicators that I track are flashing red signal. This doesn’t mean that market may crash immediately. It simply means that the asset allocation must be made a bit more conservative. Its time to book some long-term capital gain (if possible). Within equity funds, re-allocate from mid-cap funds to large cap diversified equity funds and balanced funds. I will talk about NIFTY valuation first and why such high valuation means relatively lower return going forward. In that context, it becomes essential to tweak asset allocation.
There is little doubt that equity market valuation is certainly expensive. The table below shows that the NIFTY trailing P/E ratio is almost 2 standard deviation above long-term average. P/B ratio as well as dividend yield look significantly more expensive than average valuation.
NIFTY has rarely been this expensive –
Does it mean that the market will correct soon?
Expensive valuation at the peak of earnings cycle (High P/E ratio and High EPS growth) normally can lead to significant correction. However, currently the high P/E ratio just indicates the earnings growth has been pretty weak and should the earnings growth normalize, the valuation will not be that high. In fact, the trailing P/E ratio of NIFTY is 27.66 but FY19 PE (as per Economic Times) is around 18x.
Expensive valuation alone is not sufficient for market to correct significantly. Expensive valuation coupled with tightening liquidity (demand for stocks) is needed for market correction. While valuation is expensive, liquidity (especially domestic) is ample as of now:
- Mutual fund investors have SIP investments in equity funds of around 6000 crore. In my experience, this is rather sticky and will continue.
- While bond yields have gone up, fixed deposit rates are still too low for people to think too much of investing in fixed deposits.
- Foreign investors have not invested too much in recent years. In past, when they sold Indian equity market the FII selling was in the range of 35000 to 40000 crore over 4 to 5 months. In current market, such level of selling can be absorbed by domestic flows. Since FIIs have not invested too much in recent years, it is unlikely they will sell heavily.
Risk to liquidity will come from high bond yield, higher oil price and higher US bond yield. Combined effect of these three, at some time in 2018, will weigh on Indian equities.
What return to expect now?
Equity returns are chunky and they come in lumps. Market can run high once its smells earnings recovery. When the earnings recovery actually comes, it can remain stagnant. The current high P/E ratio that a large portion of earnings recovery has already been priced in.
While it is difficult to predict market direction, it is reasonably certain that return over next 1 year will be much below than what has been the case over last 12 months. Historically, such high P/E ratio has meant negative return. Hence, the earnings must grow for market to remain supported.
Focus on asset allocation
Simply, in my view and more conservative asset allocation is needed:
- Continue SIPs/STPs as timing the market is quite difficult.
- If you have high equity allocation (80% plus), equity allocation should be reduced by booking some long-term capital gains from equity mutual fund. If the market were to correct, this can be redeployed.
- Be more conservative with mid-cap funds and invest more in balanced funds.
Disclaimer: The above content is just for information and should not be construed as an offer to buy or sell or recommendation. Contact your financial advisor for guidance on any investment related query.
If you liked the above article and would prefer to be notified when we write next, please leave your contact details below: