Stock markets often overreact: Both on the upside and downside. During bear phases, particularly during market crashes when investors resort to panic selling, stock prices go far below their fair value. Similarly, during bull runs, irrational exuberance will push up prices to unrealistic levels. This ‘manic-depressive’ nature of the market, however, opens up opportunities for investors. Warren Buffet famously exhorted investors to be “greedy when others are fearful and fearful when others are greedy”. Implementing this sound investment strategy is not easy because it is difficult to call the troughs and peaks of the market.
Valuations are high
A good strategy is to look at market valuations in relation to long-term average valuations. Let’s look at three popular parameters of valuations viz. Market cap to GDP ratio, PE multiple and Price to Book value. In India the long-term market to GDP ratio is around 77 percent; the long-term PE multiple is around 16 and the median Price to Book value is 3.23. Where are these valuation parameters now? Market cap to GDP is 110 percent, one-year forward PE is around 21 and Price to Book is 4.44. All three indicators are flashing red. However, some caveats are in order. It can be argued that market cap to GDP is higher because the denominator GDP contracted in FY21. Therefore, the expected 15 percent nominal GDP growth in FY 22 will make this ratio a bit more realistic. Similarly, it can be argued that PE multiple is higher because the market is discounting the imminent cyclical expansion in growth and profits. The same logic will hold good for Price to Book too. Another popular bullish argument is that higher valuations are the new normal in these abnormal times of humungous liquidity and abysmally low returns from fixed income and other alternate asset classes. All these arguments in defence of high valuations have some merit; but there is no denying the fact that valuations are stretched and investors have to be cautious. Partial profit booking will not be bad idea.
New kids on Dalal Street
The new kid on the street – both Wall Street and Dalal Street – is the newbie retail investor. There has been an explosive growth in retail trading accounts post the outbreak of the pandemic. Hyper retail trading activity is exerting a significant influence on market trends. For instance, in May 2021 FPIs sold shares worth Rs 6000 crores and DIIs bought shares worth Rs 2000 crores only. The market should have gone down; instead it went up by 7.5 percent assisted by retail buying. In India 14.7 million new Demat accounts were opened in FY21. This trend of newbie retail investors flocking to the market and trading from home is a global trend. Retail participation is a desirable trend from the perspective of inclusive growth. Ordinary people participating in the wealth creation through the stock market is good; but, unfortunately most retail investors are indulging in reckless trading and losing money instead of systematically investing and creating wealth.
Don’t chase cats and dogs
An unhealthy trend in recent days is the sharp rise in the prices of low-grade stocks – the so-called ‘cats and dogs’. These cats and dogs will be slaughtered in a bear ambush, which can happen any time. So, investors have to be cautious. We are in a ferocious bull market; bull markets are known to climb many walls of worries. If we are on the cusp of an expansionary growth and earnings cycle, the market may further surprise on the upside. So ride this bull; but don’t chase the cats and dogs.
Continue with systematic investment
History has taught us that wealth is created in the stock market when investors buy quality stocks and remain invested for long. As the adage goes, “to be successful in the market one needs only an average person’s intelligence but ten persons’ patience.” Market trends are volatile. The best strategy is to buy massively when markets crash and valuations become attractive. As explained earlier, now valuations are high and the market is booming. This is not the time for aggressive buying; but it certainly makes sense to remain invested and continue to invest systematically. Sharp corrections happen in a long-term bull market. Be prepared for such corrections even while enjoying this bull ride.