The market now is a heady cocktail of strong positive and negative news. The jury is still out on the short to medium-term direction of the market. There can be a sharp correction in the market any time; or, the market may consolidate around these levels; or, it may even rise further. What should investors do under such confusing market signals?
Strong rebound in growth and earnings
Let’s get the issue in perspective. FY 21 has ended with Nifty earnings growth of 14%. This is no mean achievement in a pandemic-hit year, which saw GDP contract by 7.3%. FY 22 Nifty earnings growth is likely to be around 35%. Clearly, there is a strong trend of an expansionary cycle in corporate earnings. The earnings prospects of IT, metals, leading financials, pharma, cement, energy and telecom look good. India’s top 20 companies that account for 80 % of India Inc’s profits are firmly set to improve their earnings. The global economy is rebounding with strong growth. India is expected to emerge as one of the fastest growing economies this year with GDP growth of around 9.5 %.
However, investors should not be carried away by the positive news. Markets have discounted the good news and even more. Valuations are high. It is important to appreciate the fact that this is global rally and corrections too are likely to be global. The direction that the mother market US sets will set the trend for markets globally.
Market overvaluation is an undeniable fact
Let us face the facts. Markets are overvalued. In the US, the market cap to GDP is 205 percent, way ahead of the long-term average. PE ratio S&P 500 is 46, much higher than the historical average of 16. Tech stocks are trading at fancy valuations. Back home in India, the market cap to GDP is 115%, which is uncomfortably higher than the historical average of 77%. FY 22 Nifty PE is around 21, way ahead of the long-term average of 16. So, one can logically argue that the excessive valuations warrant a correction. But the correction is not happening. Humongous liquidity created by the leading central banks of the world, and the new phenomenon of retail investors merrily investing in the market without much regard to valuations, have combined to create a new normal of high valuations. However, this is unlikely to last long. The usual indicators of a correction like a hawkish Fed, rising bond yields and signals of a recession are conspicuous by their absence. This is the reason why even pessimists are almost fully invested.
There are some general indications that signal an imminent sharp correction, even a crash. Flood of media stories of wealth creation in stock markets and huge money being made by stock investors, huge over-subscriptions in IPOs, explosive growth in new demat accounts, frenzied trading by retail investors and low-grade stocks flying away are normally signals of an imminent crash. Informed investors can discern these signals in the Indian market now. This calls for caution and a conservative approach, going forward.
Book some profits; remain invested in quality large-caps
Most investors are sitting on big profits. It makes sense to book some profits and move some money to fixed income. Keep away from low-quality small-caps, which are driven up by newbie retail traders. Remain invested in high quality large-caps in sectors like IT, financials, metals, cement, pharma and FMCG. Continue with SIPs in good mutual funds. Always remember that investing in quality compounding stocks and waiting patiently create wealth. There are no short cuts to wealth creation.