Pursue a cautious strategy in this over-valued market

“We don’t know where we go from here. But we should know where we are.” – Howard Marks

To out-perform the market you have to do things differently, that is, you have to move away from the herd. The herd can be, more often than not, wrong.  Moving away from the herd at the right time and acting against the herd instinct requires insight,  courage and lots of patience. Not an easy task.

In stock markets, globally, there is a powerful herd movement underway for more than a year now.  Markets are ferociously bullish and the herd is making a lot of money. Even bears are now fully invested. We don’t know where we go from here; we don’t know how long this rally will last; we don’t know when a sharp correction begins. But we should know where we are. That would help in better decision-making.

In valuation terms where are we now?

In the mother market US, the market cap to GDP is 205%, way ahead of the long-term average.  PE ratio of S&P 500 is 46, far 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 22, way ahead of the long-term average of 16. So, one can logically argue that 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.

Disturbing signals

There are some general indications that signal a sharp correction, even a crash. A 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; but 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 even though fixed income returns are low. There is no harm in erring on the side of caution. 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.    Importantly, invest in mid-small-caps through the mutual fund SIP route. Always remember that      investing in high-quality compounding stocks and waiting patiently create wealth.  There are no shortcuts to wealth creation.