Multiple factors to keep markets on tenterhooks after Friday's fall

Surging US bond yields, LTCG implementation, RBI policy action amid widening of fiscal deficit targets to weigh on investor sentiment

Market players are worried about the direction the stock markets will take this week, following Friday’s bloodbath in US equities and the correction in bond prices. The yield on the benchmark 10-year treasury note touched a four-year high as fears of inflation and aggressive rate hikes by the US Federal Reserve spooked investors. 

Domestically, the widening of the fiscal deficit targets has raised concerns of a reversal in the policy stance by the Reserve Bank of India (RBI) weighing on banking shares, which have significant weight in stock indices. The reintroduction of the tax on long-term capital gains (LTCG) and higher taxes on mutual fund investors have dampened investor sentiment. “Markets are richly valued at this juncture and the risk-reward does not appear attractive despite the correction. Those with a short-term horizon of less than three years may want to reduce their equity exposure,” said Gautam Chhaochharia, head of research at UBS. 

“We think the Indian market is set for a near-term correction, given that the pre-Budget rally seems to be culminating in some disappointment, particularly in the imposition of the LTCG tax. Moreover, India’s valuation premium — in terms of relative PE to MSCI Asia ex-Japan — remains at one standard deviation above its long-term average. A reversion to the mean could be on the cards,” said Manishi Raychaudhuri, head of Asia (ex-Japan), equity strategy, BNP Paribas Securities.

Investors got a rude jolt on Friday as the benchmark indices, the Sensex and Nifty, tanked 2.3 per cent. Later, the Dow Jones Industrial Average posted its worst drop since June 2016, shedding more than 650 points after treasury yields neared the 3 per cent mark. In the immediate term, the downward pressure on the market is likely to persist as investors move from equities to bonds due to the change in risk premiums, according to experts.

“Globally, it is all about what will burst the liquidity bubble. Bond prices have started to tumble and that is worrying,” said Andrew Holland, chief executive officer, Avendus Capital Alternate Strategies. “There is going to be a lot more volatility and the real pain will be in the mid- and small-cap space.”

Experts say any attempts at recovery could be capped at January 31 levels due to the manner of implementation of the LTCG tax. Any appreciation in the value of the stocks up to January 31 is tax-protected, while any increase in value from January 31 up to the date of sale after April 1 is taxed at 10 per cent. The weeks running up to March 31 are likely to see some profit-booking from investors wanting to save on the 10 per cent tax on LTCG, say experts. “Selling pressure is likely to persist, so hedge or reduce leveraged positions. For hedging, one can buy a put at the 10,700 levels. Fresh buying can wait till the market stabilises,” said Chandan Taparia, derivatives analyst at Motilal Oswal Financial Securities.

What should investors do?

Experts say this is the time for investors to take a long, hard look at their asset allocation and take more chips off the equity table. According to them, small- and mid-cap stocks have entered a bubble zone and more than half of these are trading at 20-25 times their one-year forward earnings multiples. “Even now it is not too late. If the valuation comfort is missing, do not hesitate to take profits,” said G Chokkalingam, founder, Equinomics Research & Advisory.

“From a valuation perspective, large caps offer greater comfort. Investors should allocate at least 50 per cent to large caps, 30-35 per cent to mid- and small-caps and keep 5-15 per cent in cash,” Chokkalingam said. “Keep fixed stop losses and move out of underperformers, and those that have disappointed on the earnings front consistently,” said Prasanth Prabhakaran, chief executive officer (CEO), YES Securities.

“Investors with an active portfolio can convert 25-30 per cent into cash. That way if their call goes wrong, they can still ride the market with the remaining 75 per cent. If the market tanks, their losses are minimised,” said Rahul Rege, business head, retail, Emkay Global Financial Services.

“The only way to move around the LTCG is to buy high-quality stocks that you do not have to sell for years. So, if you hold a stock for three years you pay LTCG in the third year, helping you compound even that money that would have earlier gone for tax payment otherwise,” veteran investor Basant Maheshwari, said in a tweet.

“Since the LTCG is a deferred tax, the longer the holding period, the lesser will be the effective tax. Investors will now have to be doubly careful in selecting equity schemes and ensure a holding period of at least 5-10 years,” said Feroze Azeez, deputy CEO, Anand Rathi Private Wealth Management.