Index investors can put surplus in short-term deposits to invest during corrections.
The fundamental logic of stock market investment revolves around two key variables – growth (in both turnover and profits) and interest rates. The best-case scenarios arise when growth is high and interest rates are low at the beginning of a boom. The worst long-term scenarios involve stagflation – a combination of rising inflation and stagnating growth.
When there is a situation of rising rates and rising growth, the glass is half-full or half-empty, depending on personal optimism. Good investments can be found. But the investor must be selective and prepared to live with higher risk.
The combination – rising rates and growth – occurs at some stage in every cycle. Provided growth momentum is maintained and rate hikes are moderate, bull markets can be sustained for indefinite periods. Inevitably, the market peaks when growth slows and rates continue rising.
Indian interest rates have risen steadily through the past year. But the growth momentum has also been maintained. As a result, the stock market has given reasonable returns. It’s not clear how much longer this situation will be sustained since, although GDP growth is projected to accelerate through calendar 2011, earnings growth shows signs of slowing down.
As of now, stock market valuations are rich, despite the recent correction. The Nifty is trading at a weighted average price earning (PE) of 22 (on the basis of the last four quarters’ EPS). The dividend yield at current prices is around 1.1 per cent and the price-book value ratio is above 3.7. The PE is well above the long-term average of 18. The price to book value (PBV) is just above average (3.6). The dividend yield is below its average (1.5).
These valuations have been sustained for many months. But all of them are in dangerous territory. These are all mean-reverting ratios, which means that they don't deviate too long from their long-term average values. The dividend yield and PE are both at the edge of their respective means plus/ minus one standard deviation and a conservative investor would consider both ratios to be on the verge of sell signals.
The fundamental take on PE is that it cannot be justified in comparison to risk-free returns. A PE of 23 (which can be inverted to calculate earnings over price) would be fair-value only if the risk-free interest rate was below 5 per cent. As of now, treasury bills are being auctioned at 7 per cent and there’s consensus that rates are likely to move higher before they move down.
The PE could be justified on the basis of PEG (PE-growth) ratios only if future earnings growth is 23 per cent or better and a PEG of 1 is maintained. In the past four quarters, EPS growth has been in the range of 14 per cent.
The first half of 2010-11, when EPS growth was negatively impacted by rising interest costs, doesn’t inspire confidence that such a significant acceleration will occur. The best hope may lie in VST being implemented sensibly and without start-up glitches in 2011-12. That would enable better corporate performance by removing a major source of friction.
But it’s asking a lot for VST to be an instant booster. Otherwise, the current valuations imply there isn’t much in the way of a safety margin right now. Buying stocks across the board, or a simple accumulation of index funds could both be sub-optimal strategies.
Unfortunately there aren’t too many defensive measures available if the overall situation tips over into bearishness as it may already have done. There are few counter-cyclicals that really do well during high inflation periods.
The best chance of finding such counter-cyclicals in India lie in the the oil and gas exploration and production (E and P) sector. There, the problem is the arbitrary nature of government policy . Defensive sectors like pharma and FMCG retain value better during high interest regimes but at best, that prevents excessive capital erosion.
If you’re prepared to play the short side, there are of course, likely to be plenty of opportunities. But a classic long-term investor implementing buy-and-hold strategies is not going to be very comfortable with shorting. Hedging by buying deep out of money puts on the Nifty is also possible but the hedging costs could add up.
It’s not a very comfortable scenario. If you’re an index fund investor, I’d suggest you park emergency surplus fund in short-term deposits to be deployed upon any substantial correction. That would reduce the average cost of acquisition. If you’re an active stock picker, avoid high debt plays and give greater weight to low valuations, than to growth prospects.
