In December 2009, most signals looked positive. GDP was picking up, earnings growth was good, interest rates low. The environment looks less positive now. The primary concern is interest rates. Rates have risen through 2010 and may rise through 2011.
That hasn’t choked-off growth yet. But it cuts earnings expectations, and “fair value”. The first half of 2010-11 saw turnover and PBDIT growth. But earnings lagged because interest costs have jumped. The Nifty is at PE 24 (last four quarters EPS weighted by market cap).
Comparing earnings yield to debt yield, PE 24 is “fair value” versus a risk-free return of 4 per cent. T-Bills are now being auctioned at 7 per cent. This implies the current fair valuation is nearer PE 15. It would require an extraordinary EPS growth (60-70 per cent) to pull PE back to 15 if prices stay at current levels.
So, 2011 may have more downside than up. Nor can we expect positive policy initiatives. Policy in 2011 will be hostage to the fallout from multiple scams and the compulsions of assembly elections.
The positives if any, would come from overseas. In 2010, the FIIs propped up the market. If they continue to pump in money, desi perceptions are irrelevant. One can’t read FII attitude – it depends on too many different variables and will become apparent only post-Budget.
An investor with a diversified portfolio could seek to implement one of the two strategies, at least until June 2011, or so. One is a staggered investment system, where equity exposure is increased, if the market falls. This is like a Martingale betting system where stake is increased on a loss.
Such a method reduces the average cost of acquisition by a greater degree than EMI-style cost-averaging, as in normal systematic investment plans (SIP). A “martingale-SIP” might, for example, add 20 per cent to monthly commitments if the portfolio value falls 5 per cent, and increase commitment by another 20 per cent on every subsequent 5 per cent fall.
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Another method is to hedge via deep, long-term puts or bearspreads. For example, a June 2011, 5,400 put, (10 per cent off the money), is trading at a premium of 108 while the June 2011 5000p is trading at 70. There's ample liquidity in both series.
A long 5,400p and short 5,000p combination creates a bearspread with a net cost of 38, and a breakeven at 5,362. The potential return is 362, if 5,000 is hit by June. This bearspread costs about 0.6 per cent of the Nifty at current value. Therefore, it protects against any downside of over 10.6 per cent before June (similar hedges can be taken for later expiry).
Both these are dynamic strategies. Neither is tough to implement. Any widely-diversified equity portfolio can be protected to some extent by using similar methods. To hedge, using Nifty puts, you need to calculate the portfolio's correlation and beta versus the Nifty.
Consider these strategies. Here’s hoping it’ll be a Happy New Year for bulls, but either of these could help avert major trauma if it's not. The author is a technical and equity analyst