Strong flows not enough reason to buy equities: BofA-ML

The sharp inflow into equity mutual funds (MFs) isn’t sufficient reason for investors to buy equities. For, the valuations remain elevated, says Bank of America Merrill Lynch (BofA-ML), advising investors to “stay cautious in the near term”.

In May, equity schemes got inflow exceeding Rs 10,000 crore for a second month. In general, since May 2014, inflow has consistently been strong.

“As the markets run out of bottom-up arguments (such as earnings, valuations), investors increasingly point to the strength of domestic equity flows as justification for further upside,” say Sanjay Mookim and Nafeesa Gupta, analysts at BofA-ML. Their note says “flows are a weak argument”. Very few stocks are cheap on an absolute basis and evaluations remain elevated, they add.

According to BofA-ML, part of the reason for high investor flows is rising markets and relatively unattractive returns in debt and real estate. However, these arguments could be reversing.

“Real rates have already turned positive with the recent collapse in consumer inflation. The risk to domestic inflows, then, is a combination of falling inflation expectation and declining equity return expectations, which would happen if the market corrects meaningfully. While it might seem unassailable now, the incoming tide of domestic liquidity can reverse,” say Mookim and Gupta. They add that investors would be content with a five to six per cent, post-tax, three-year debt return.

Also, high domestic flows do not necessarily mean a higher market. According to BofA-ML, there is only a 65 per cent correlation between net flows (MFs and foreign institutional investment, less equity issuance) and Sensex monthly returns. In other words, historically, there have been months when the market has fallen despite positive inflow.

The bank analysts say a large portion of new flows would get absorbed by new equity issuances. “Even if domestic MF inflows remain high, net flows can diminish as issuances increase. year-to-date issuance is already more than 70 per cent of 2016. The pipeline for new equity raised is also reasonably large. Much of this comes from the government, which has budgeted relatively large revenue from divestments in FY17,” they say.

In the past year, average inflow into equity MFs has been a healthy Rs 7,000 crore a month. These have remained strong despite the market scaling new highs.

“Buying stocks at all-time high valuations on the assumption that domestic flows will continue ad infinitum and insure from downside might be dangerous. Such investors should avoid risk now,” says the note by BofA-ML, which has a December 2017 Sensex target (estimate of where it would be) of 30,000. On Thursday, the 30-share blue-chip index closed at 31,076.