Cash Out Of Equity Mutual Fund
The current market volatility indicates that your portfolio needs to be rebalanced while booking profits. On the asset allocation front, the equity sentiment index suggests allocating 60 per cent to equities and 40 per cent to debt. The article explains why
second half of 2020 and year-till-date have proved to be quite spectacular for the equity markets. This has attracted a lot of investors who are now investing with the anticipation of earning hefty returns. Though the markets took some pauses in between, overall it was in an uptrend. In November 2021, however, Nifty 50 disrupted its six-month winning streak by ending around 4 per cent lower at 16,983. In the previous month i.e. October 2021 we also witnessed elevated volatility where the benchmark equivocated in a wide range of around 1,400 points and saw a pullback of nearly 8 per cent from the all-time intra-day high made on October 19, 2021. Despite the recent hiccups, the returns earned by mutual fund investors are exceptional. As shown in the table below, the returns are quite high from a historical perspective. Even the route of systematic investment plan (SIP) is generating higher returns. Thus, should the movement of equity indices over the past few weeks prompt you to book profits in this period of heightened volatility?
This volatility can be very much attributed to global factors such as Federal Reserve’s taper announcement, surging bond yields, higher crude oil prices and strengthening of the US Dollar index. Moreover, on November 26, Omicron, which is the new variant of corona virus, was detected in South Africa. This further battered sentiments across the global equity markets. With the market heading southwards, subdued sentiments and uncertainty pertaining to the Omicron variant, a prime question is whether this is the right time to book profits from equity mutual funds? To answer this question, in the following paragraphs we have analysed the market valuations, looked at what high frequency indicators have to say and also studied the SIP rolling returns in order to arrive at a logical conclusion.
As can be seen from the above graph, large-cap, mid-cap and small-cap indices have surged quite high from the lows made in March 2020. In this period, mid-caps and small-caps have outperformed large-caps. However, since the second half of October 2021 the market has been witnessing some downward pressure. In fact, presently Nifty 50 is trading below its 50-day and 100-day exponential moving average (EMA). However, the price is still way away from the 200-day EMA.
Market Valuation
There are various ways to understand whether the markets are expensive or cheap. That said, no one way is perfect if viewed in isolation. Therefore, we would be looking at various factors to gauge the current market valuations.
Nifty’s Forward and Trailing PE and PB
Price to earnings (PE) and price to book value (PB) remain the most conventional ways of gauging the valuation of the market. Nifty is presently trading at a 12-month forward PE of 20.6 times, which is 8 per cent premium to its 10-year average of 19.1 times. This can be seen in the graph below.
The forward PB of Nifty is currently hovering at 3.2 times, which is around 23 per cent premium to its historical average of 2.6 times as represented by the red dotted line in the graph below.
Even the trailing PE and PB tell you no different story. Nifty’s 12-month trailing PE is at 25.5 times, a 23 per cent premium to its 10-year average of 20.7 times. And at 3.5 times, the 12- month trailing PB of Nifty is above its historical average of 2.8 times.
From the above graphs of trailing and forward PE and PB multiples, we can see that the markets are quite expensive now. Higher valuation is justified if we see a continuous upgrade in earnings. Though the last quarterly results met expectations, the strong upgrade in earnings was conspicuous by its absence and hence higher valuation needs to be cooled off.
Yield Curve
After the equity market let us look at what the debt market is signalling. Here we would be looking at the spread between 10-year and three-month government bond yields. It is believed that when the three-month yield is greater than the 10-year yield, the markets tend to fall.
As can be seen from the graph above, the spread between the 10-year and three-month yield is quite high and it seems to be in quite a comfortable zone. Historically, we have seen the curve Inverting as indicated by the red line in the graph but since the year 2018 the spread has not even breached its historical median as indicated by the black line. So, this metric suggests that the valuations presently are comfortable until and unless we do not see a sharp increase in the three-month yield.
Market Capitalisation to GDP Ratio
Market capitalisation to GDP ratio is one of the most favourite valuation matrices used by legendary investor Warren Buffet and hence it is also popularly known as Buffett indicator. This valuation model compares the total market capitalisation of the stock market with that of GDP.
It seems that the valuation based on market capitalisation to GDP is stretched quite a bit. It is presently trading at 151 per cent as against its historical exponential average of 110 per cent. Therefore, the Buffett indicator also suggests that the market is overvalued.
SIP Rolling Returns
The rolling SIP return is also one of the indicators of how stretched the markets are. In order to understand the same, we have three-year SIP rolling returns of Nifty 100 Total Returns Index (TRI), Nifty Mid-Cap 150 TRI and Nifty Small-Cap 250 TRI as a proxy to large-cap, mid-cap and small-cap funds returns, respectively, to get a better grasp of category-wise return expectation going ahead. The period of study is from December 1, 2005 to November 30, 2021.
Above are graphs showing three-year SIP rolling returns of Nifty 100 TRI, Nifty Mid-Cap 150 TRI and Nifty Small-Cap 250 TRI. Historically, in case of all the three indices, returns heading above one and two standard deviations have reverted to the mean. In a few instances, it has also moved below its historical average, making it a good opportunity to enter the market. Currently, all the three indices are above the one standard deviation of mean returns.
Sector Valuations
Equity mutual funds also offer sectoral funds which invest primarily in stocks from a specific industry. For example, a fund dedicated to banking and financial services would invest in stocks such as HDFC Bank, ICICI Bank, SBI Bank, ICICI Prudential Life Insurance Company, LIC Housing Finance, and so on. Mutual funds prominently offer funds specific to sectors such as financial services, infrastructure, pharmaceuticals and technology. The graphs above illustrate the valuations of the financial services, infrastructure, pharmaceutical and IT sectors. The financial services’ sector’s valuation ratios are currently trading below their historical average, making it an attrac- tive option.
Nifty Infrastructure and Nifty Pharma valuation measures are hovering near their negative one standard deviation, making them more appealing from a long-term viewpoint. On the other hand, Nifty IT’s values appear to be fairly stretched, since it is trading above the one standard deviation. So, investors may consider some profit booking in the IT sector-dedicated fund.
Future Outlook
Considering all the foregoing valuation methods, it is clear that the markets are trading at a valuation higher than the historic average. Even on a forward PE and PB basis, the valuations are high. However, in the near-term the market will be intently tracking the information released by scientists on the Omicron strain from this point forward. The US’ president has stated that getting definitive data on the Omicron will take at least two weeks. It could take a few more weeks to learn more about the virus strain and its potential consequences. Uncertainty irritates people and hence they try to move to safer asset classes. Foreign institutional investors (FII) may change their asset allocation from emerging market equities to US Treasury bonds in such uncertain times. As a result, investors can expect heightened volatility.
The market will adopt a clear path once it has greater clarity on what to expect in the future. The market will attempt to analyse the economic implications of another virus wave in the near term and will react to new information as it becomes available. There is no need to read too much into short-term market moves, whether they are upward or downward. Expect the market to be volatile with a downward bias because risk variables are often amplified in prices when risk aversion sets in. Due to the impending holiday season, the market might trade with lower volumes in the last two weeks of December. During this time, you should remain patient and avoid making quick decisions.
That said, long-term prospects seem to be promising. Our economy is fuelled by domestic demand. The Indian economy is exhibiting significant indications of revival after a tough FY21. According to data from Ministry of Statistics and Programme Implementation, the Gross Domestic Product (GDP) growth in the second quarter of FY22 was 8.4 per cent compared to a 7.4 per cent decline in the previous fiscal year. The prognosis for earnings’ growth is likewise promising. Sales throughout the holiday season were really positive. With the services sector reopening following pandemic-related limita- tions, we may see strong Christmas sales.
From a medium to long-term view, the current correction, along with increased profit growth in the coming quarters, would give a good platform for better future returns from Indian equities. The key to long-term return is to have an asset allocation strategy in place. It is advisable to have suitable asset allocation with the optimum mix of equity and debt mutual funds in these volatile times. However, you must decide on the type of financial aim to
which this portfolio will be allocated. If you are putting together a core portfolio, strategic asset allocation is the way to go depending on your risk tolerance, financial goals and time horizon. However, you can use tactical asset allocation for a satellite portfolio to dynamically transition between equity and debt.
For this, advanced techniques like as the Equity Sentiment Index® can be used or in the absence of such tools, a crossover of the 50-day and 200-day moving average can be used to make switch decisions. When the 50-DMA of Nifty crosses the 200-DMA, begin to progressively shift from equities to debt and vice-versa. The equity sentiment index now suggests an asset allocation of 60 per cent equities and 40 per cent debt. The idea behind employing an equity sentiment index is that it advises investors to accumulate when others are fearful and leave when others are greedy. As a result, for your satellite portfolio, you can adjust your asset allocation accordingly.
The Exit Option
The markets would be volatile in the medium term due to the uncertainties surrounding the Omicron variant and climbing inflation. However, long-term prospects for equities remain favourable. The current valuations appear to be fairly high. Nifty’s 12-month forward PE ratio is trading at an 8 per cent premium to its 10-year average while its PB ratio is trading at a 23 per cent premium to its historical average. The market capitalisation to GDP ratio, which is hovering at 151 per cent, also signals stretched valuations as it is significantly over its historical exponential average of 110 per cent. Even the three-year SIP rolling returns of the Nifty 100 TRI, Nifty Mid-Cap 150 TRI and Nifty Small-Cap TRI are higher than the historical average, indicating that the equities are overvalued.
Despite higher valuations, there are sectors that demonstrate there are some pockets of attractive valuations, such as financial services, pharmaceuticals and infrastructure. On the other hand, valuations in the IT sector have skyrocketed. As a result, mutual fund investors may consider including banking and financial services’ funds, infrastructure funds and pharmaceutical funds in their satellite portfolio. They must also consider booking some profits from IT or technology funds.
Investors should, however, stick to their asset allocation for their core portfolio. The current volatility indicates that your portfolio needs to be rebalanced while booking profits. On the asset allocation front, the equity sentiment index suggests allocating 60 per cent to equities and 40 per cent to debt. SIP investors should re-balance the total amount accumulated, but not halt their SIPs. As the market declines, SIP will assist you in accumulating more units at lower NAV.