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Are Markets Over-valued?

Yes, suggests the higher cash or debt allocations being taken by some equity funds

Actions sometimes speak louder than words. The main valuation indicators for Indian market, the price-earnings multiples of the Nifty and Sensex, are now at 23 times and 20 times respectively. Yet if you ask fund managers if the stock market is over-valued, you don't get a definitive answer.

Some say that while valuations are 'not cheap', corporate profits have been low in recent years and therefore, the PE seems exaggerated. Others say that as previous bull markets topped out at 25-26 times, there is plenty of headroom for stocks to move up further.

But a better answer to this question emerges from the portfolios of funds that take an active call on market valuations. There are several schemes in the equity space which promise to protect downside for investors, by timing their equity investments depending on market valuations. If they think the markets are over-valued, they book profits on stocks, reduce equity allocations and move into cash or debt to reduce the impact of a correction on their NAV. What are these funds doing now?

If you look at their portfolios, you get the sense that the market (or at least pockets of it), is richly valued. Take Quantum Long Term Equity Fund, which adds to, or books out of its portfolio holdings based on stock valuations. The fund has steadily raised its debt/cash positions in the last one year while reducing equity allocations. The debt/cash position climbed from 19.3 per cent in March 2014 to over 30 per cent in subsequent months and has since stayed at the 30-33 per cent levels. Quantum Tax Saving Fund has followed a similar strategy with debt/cash levels of nearly 20 per cent now.

ICICI Pru Dynamic Fund, another fund which has proved quite successful at market timing, has maintained a 20-25 per cent debt and cash allocation for the last one year. In recent months, it has increased its holdings in g-secs to improve returns, but held its equity allocations at 75 per cent.

Or take Franklin India Dynamic PE Fund, which juggles between equity and debt funds from the same house, based the PE levels in the market. Because the Nifty PE, has climbed to above 20, this fund has gone from a 60 per cent equity allocation a year ago to a 45 per cent allocation by March 2015. As per its mandate, the fund reckons a PE of upto 12 times, as most reasonable for the markets and takes on 90-100 per cent equity allocation at this level. A PE of 28 or more is seen to be too high, when equities are cut to 0-10 per cent of the portfolio.

To be sure, each of these funds has paid a price for their lower equity allocations in a rising market. Quantum Long Term Equity and ICICI Pru Dynamic, which are top long term performers in their category have slipped in the one year return rankings. Their returns of 29 per cent and 33 per cent respectively have hugely under-performed category-toppers, who have managed 60-65 per cent in one year. But if you are a conservative investor who wouldn't like his portfolio to be battered in a market correction, you should be happy. If the markets do turn out to be over-valued and do a sudden about-turn correction hits, these funds will survive the rout better than peers.

Even for investors who aren't invested in these funds, their allocation calls offer some cues. The markets aren't cheap and if you need your money within three years, take some off the table now.