Investment Strategies For Different Market Conditions

One of the essential conditions for an active fund manager to outperform the market is a dispersion in the returns of the equity market. In simple words, if returns are smooth then anyone can invest and earn, it is the variation in the returns due to various conditions that help a fund manager to generate better returns. They use their skills and experience to understand the dynamics of the market and position themselves to take advantage of the situation.

The current situation in the Indian market looks to be very volatile with a downward bias. Despite all the attempts made by government (by way of cut in corporate tax rate or frontloading of PSB capitalisation) and the RBI (interest rate cut by more than 1% in the last six months) to kick-start the economic growth, we have still not seen any visible change on the ground. In addition to the domestic factor, what has led to such dampened sentiment is the global situation. This is evident from the rush for safety, with gold and long-dated US treasuries being the best performing asset classes for the month. Despite this, if you look at the performance of the indices of different market caps, there are some clear winners that have generated positive returns in the last one year. The graph below clearly shows that in all the periods that we have taken in one year, the large-cap dedicated index Nifty has outperformed other indices.

Nonetheless, if we take a longer horizon, the picture changes drastically. In the five-year period ending October 6, 2019, mid-cap and small-cap dedicated indices have generated better returns than large-cap indices.

Not only this, there are periods when debt, which is considered a boring investment, has performed better than the equities. For example, in the last one year, long-duration bond funds have on an average generated returns in double digits.

In this situation, when different asset classes perform differently in different conditions, and within the asset class also, there is variation in returns, it becomes imperative for an investor to understand these cycles and invest accordingly. The strategy one can use is to check how the different asset classes have moved in different conditions.

One of the most common ways to figure out where to invest is to know the valuation of that asset or asset class. The markets may be irrational for a shorter period; however, in the longer term, it is the current valuation that determines the future returns.

The next difficult question is: how to determine the valuation of the market? There are different parameters used by different investors to gauge the valuation of the market; however, the most popular is a price-to-earnings (PE) ratio of frontline indices. It has been observed that if the PE of the frontline index such as Nifty is greater than 25, most of the time the returns generated by them are negative for next 6 -12 months. However, it will be too naïve to depend upon a single parameter to ascertain the attractiveness of the market. Therefore, experts take a combination of different indicators to know where to invest now.

We have taken one of the popular indicators constructed by the combination of PE ratio, price-to-book value (P/B), market cap-to-GDP and dividend yield. We have given equal weight to every component and constructed a composite valuation indicator. If you are interested in constructing this indicator to make your investment decision, you can get all the data from the websites of stock exchange and RBI.

We have observed that there is an inverse relationship between this composite valuation indicator and the next three-month, six-month and one-year return. This means that when the current value of the indicator is high, the future returns will be lower and when the value of indicator is low, the future returns will be higher.

The dark blue line in the above graph show the composite equity valuation indicator (right vertical axis, 'Evalue') has moved and the returns in the next three, six and twelve months (left vertical axis). The straight line is the current value of the indicator. What is disturbing is that whenever the indicator hovers around the current level, the next three, six and twelve-month equity returns are negative in most of the cases.

Now let us check what happens to the broader indices such as Nifty Mid-cap and Nifty Small-cap. Since these indices have a shorter history, we have lesser data to do research on.

Nonetheless, the relation is again inverse and these indices move in the opposite direction.

The current reading shows that for the next few months, the returns will continue to be negative. This is even true for the Nifty Small Cap. The chart above clearly shows that the next three months will remain tepid.

The equity valuation indicator still shows that equity as an asset class will continue to generate anaemic returns for at least next three to six months. However, the recent cut in corporate tax rate may spur the earnings and hence this equity valuation indicator may come down, which will trigger better equity returns going forward. As an investor, you can start allocating your resources towards mid-cap funds and stocks in a staggered manner, provided your risk profile allows it, as the chart shows that they tend to generate superior returns from the current valuation indicator.