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Aren’t the markets over-valued? Does it make sense to book some profit and re-deploy after a correction? Perfectly valid questions; considering how quickly we’ve rallied to an all time high from a severe global crisis. From a drop of almost 40% in March last year, the Nifty has rallied a little bit over 85% as this is being written.
At BlueFort, we’ve been pretty consistent with our answer; any profit derived from attempting to time the market (even at what seem like extremes) is usually luck, not skill. It cannot be consistently done in the long run and is a damaging approach for the portfolio. In our opinion there are only two convincing reasons to redeem from the equity markets.
For an upcoming objective.
Re-balancing to maintain optimal asset allocation
We hope the following points aptly demonstrate our point of view:
1. Valuations are extremely subjective – Most argue that the markets are over/under valued by looking at commonly used valuation metrics. The most popular one is the price to earnings (PE) multiple. This ratio is calculated dividing the stock price by it’s earnings per share. In other words it tries to gauge if the stock price is moving in line with its fundamentals i.e. the company’s earnings. If the PE multiple is higher than it has been in the past, the stock is construed to be over-valued and vice versa. While the PE multiple is a quick and useful tool, it offers very little value to serious investors. The following example shows why –
In this case, the investors get a different PE depending on their earnings expectations. The point being made is that valuations can be extremely subjective. Markets are forward looking and a high PE multiple can also mean that market participants are expecting tremendous growth, a perfectly good explanation for the recent influx of FII money. Of course, expectations can be wrong.
2. Getting the timing wrong can be a costly mistake – The recent rally has pretty much been a concern right from April 2020. In fact several investors have lost potential returns from sitting on the sidelines, anticipating the markets to crash again as Nifty went from 7610 on 23rd March, 2020 to 9,000 then 10,000 and now 14,300. A study by JP Morgan asset management shows the impact that pulling out of the market can have on a portfolio. If you missed just the 10 best trading days in the S&P 500 index from 1st Jan, 1999 to 31 Dec, 2018 you’re annualized return drops from 5.62% to 2.01%. Missing the top 20 trading days would mean a negative return.
Data shows that equity markets will keep you under the water most of the time. But there’ll be short unpredictable periods where the market shows extreme generosity. And if you’re not there for the party then, you’ll have to kiss your returns goodbye. A similar study has also been done by Value Research for the Indian markets. – https://www.valueresearchonline.com/stories/33967/sitting-out-the-best-days-can-cost-you-dear/.
3. Putting things into perspective from a behavioural standpoint – Recency bias is a strong influence on investor behaviour. We tend to give greater importance to the most recent event. Consider this; the markets had reached 11,069 back in Jan, 2018. From then to now i.e. 14,327 as on 8th January, 2021, its grown at a CAGR of 8.90%, which is significantly below the long term average of 12%. However comparing from March 2020, the growth of 85% seems mind boggling. Had there not been a pandemic, the current levels wouldn’t even be questioned.
Yes, the virus has adversely affected the economy and earnings of most companies but the effect is far more limited than we first thought. Controlled mortality rates the release of effective vaccines has made it clear that fundamentally strong businesses will have subdued earnings for a few quarters at the most; hardly relevant considering most experts discount several years worth of predicted earnings before buying into a company’s stock. It’s now evident that the crash in March 2020 was an extreme over reaction. Quite simply put – we had a problem, we dealt with it, and now it seems to be under control (so far). The markets are now viewing the virus as an inconvenience rather than a permanent problem.
It’s not your job to assess market valuation – If you’re a mutual fund/PMS investor which has been our preferred route for equity participation, it’s important that you place faith in your fund manager. Your fund manager is far more conscious of market movements and valuations. They may increase cash holdings, sell the over-priced stock to identify underpriced opportunity, etc. It’s also important to realize that you’re not invested in the index (e.g. Sensex or Nifty). Making changes in your portfolio by looking at index levels/valuation isn’t a good idea as the correlation between your fund and the index may be limited. There are also funds that have the discretion to switch between asset classes (dynamic asset allocation funds) that may be appropriate for beginner investors.
The intention of this article is not to make a prediction on the market. It’s to demonstrate that sitting on the sidelines, or trying to profit from anticipating a correction/crash is a not a fruitful approach in the long term. Volatility is only a risk should you choose to make it one. Our recommendation would be to stick to a staggered approach of investing that is in line with your portfolio’s objectives and asset allocation.