Strategies that fund managers employ in overheated markets
29-Jan-2018 •Aarati Krishnan
As 2017 ends and a we step into a new year, a heated debate is on in the markets: whether Indian stock market is just warming up for bigger things or is already too hot to handle.
The bearish camp has quite a few arguments to back up its view that the market is superheated. For one, it argues, Indian market valuations are clearly in the expensive zone. The price-earnings multiple of the BSE Sensex stands at 24 times on a trailing 12 month basis and that of the Nifty 50 is at 25.9 times. Those valuations are way above the 10 year average of 18 times.
More worryingly, in the past, a market PE of over 24 times has often been the inflection point at which big bull markets were halted in their tracks and corrective phases began. The infamous dot-com boom of 1998 to 2000 reached a turning point when the Sensex PE hit 24 times in February 2000. The extended bull market of 2003 to 2008 hit a brick wall when the Sensex PE topped 25 times in January 2008. Based on back-tested data, dynamic asset allocation models used by Indian AMCs consider equity markets cheap at a Sensex PE of 15 or below and expensive at a PE of 22 and above. We are certainly at the higher end of that zone.
To those who track behavioural indicators, there are sections of this market that are exhibiting signs of irrational exuberance. Frenetic action in the IPO market has always signalled bull market tops. Data from Prime Database tell us that primary offers have already raised Rs 74,267 crore in FY18 (until end November). This is the highest level of fund raising in the last 20 years and has surpassed the record Rs 52,219 crore mopped up in FY08. High oversubscription numbers for IPOs, sky-high valuations for some of them and quick listing gains also point to a bubbly primary market.
Retail inflows into equity mutual funds have just hit the Rs 1 lakh crore mark for the third consecutive year. To some, this is just another indicator of a fizzy market. After all, retail investors are notorious for being last to the party. The plentiful SMS tips and Whastsapp forwards on unknown penny stocks flooding our media indicate that speculative and operator activity is in full flow in today's market.
Of course, there are optimists who offer equally convincing arguments that Indian stock markets still have a long way to climb. One, while the market appears expensive from a PE perspective, they point out that it is still moderately valued from a price-to-book-value perspective. The PB of three times is far lower than the five to six times at which past bull markets topped out.
Two, the market PE looks magnified because the denominator 'E' is exceptionally depressed. Earnings for the Sensex and Nifty companies have grown at a single digit CAGR for the last six years. Once profit growth for India Inc 'reverts to mean' and delivers double-digit growth, the PE will look much more reasonable.
Three, they also believe that the domestic money flooding into equities is of a more structural and sustainable nature this time around. With retail investors in India taking to equities in a big way, domestic liquidity is expected to put a floor on market declines, even if there's a concerted pull-out by FIIs.
At this juncture, it is extremely difficult to say which camp is right. But given that equity funds have delivered strong gains in the last five years, it is certainly better to be safe than sorry. After all, fund investors did lose a lot of money to the big market meltdowns of 2000 and 2008 after an uninterrupted joyride in the bull markets that came before them.
Given that market valuations in PE terms are elevated and we've enjoyed three years of high fund returns, what strategies are AMCs using to shield their investors from market risks? We talked to a few leading fund managers to find out, hoping for some takeaways for ordinary investors.
We will reveal more about this in the course of this week.