Be greedy when others are fearful and be fearful when others are greedy. – Warren Buffet
Indian stock markets have taken a good leap forward after the exit polls declared the return of NaMo led NDA with a stronger mandate. This has bolstered the confidence of bulls on the back of expected continuity of reforms push. Although a stronger mandate ensures that there would be lesser obstacles in bringing and implementing reforms, any tangible gains from it would appear a few years down the line.
Moreover, the current valuations (29x Nifty TTM PE) more than discount the future rosy picture. PE ratios are highest in the last 20 years despite slowing domestic GDP growth rate, falling consumer demand leading to lower earnings growth and turbulent global economic environment. The absurdity of the Global economic scenario can be assessed by the fact that many bonds are trading at negative returns, which was unthinkable a decade ago. The universe of negatively yielding bonds across global bond markets has expanded to $11.3tn.
The market is driven by sentiments in the short term but is a slave to the earnings in the long term. In the last 4 years, Nifty earning growth has been abysmally low at 2% CAGR but Nifty has grown at 8% CAGR. There is a huge fundamental mismatch in earnings growth with market price growth. Although, the mismatch corrects itself over the long term – either the earnings start growing at 20% for the next 3 years or PE ratio contacts to its long term average of 19x (a downside of 34% from current levels) or a scenario somewhere in between. The odds of a 20% growth over the next 3 years seem to be low and thus the risk-reward for equity seems very unfavorable. Even 20% CAGR with PE mean reverting to 19x will generate net CAGR of only 9% over the next 3 years, not good enough returns from equity investments.
Global liquidity sponsored by the US and other developed economies has been providing cheap fuel for the markets to rally over the last many years. The normal nature of the market is volatile where one witnesses downside and upside many times in a year. This natural volatility is absent for the last many years. Below chart gives a fair understanding of market valuations over the last many years. Red indicates over pricing and green represents fair/cheaper pricing.
Should we ride the momentum wave?
An over-priced market can get more over-priced in a momentum play. Trying to be the part of that momentum could be very dangerous as nobody knows when the reversal happens. And when that happens, it is rapid and it becomes extremely difficult to come out of the equity market. This was experienced by many investors in mid & small cap space last year when many invested thinking there is no end to the rally. Our investment portfolios were not hurt since we exited entirely from mid & small cap owing to excessive valuations. Despite the corrections, the current PE ratio of more than 30x in mid and small cap indices don’t offer any valuation comfort.
Where are we in the Sentiment Cycle?
After observing the behavior of the investment community, these are the exact times in the sentimental cycle which brings out the feeling of FOMO (Fear of Missing Out) and carries high investment risk. These are the opportunities which offer good exit points which we later realize, with the benefit of hindsight, when they pass away. Click here to read our articles on market cycles and investment lessons from history.
Investment Strategy: It pays to be a contrarian
The best strategy in the current market is to be patient and let the euphoria die down leading to softening of prices to the levels where the expected future returns on equity over the 3 years period are at least 12% CAGR. Successful investing is all about investing at right prices and managing downside risk – only component under our control at any given moment. Everything else is just speculation. Beware of the sentiment cycle, lest its strong power engulfs you into committing a serious error by defying the logical thinking of buying low and selling high.
Also Read: Beware of outcome bias while investing