The question everyone wants an answer for…

You have often heard about the adage “Buy Low – Sell High”.

Now that markets are at an all-time high, shouldn’t you SELL HIGH? 

Fair enough. 

A lot of Indian equity mutual fund investors seem to be taking this view and are redeeming from equity funds in the last few months.

But here is where the story gets interesting.

Take a wild guess on what our foreign counterparts are doing?

Brace yourselves. Foreign investors are just doing the opposite – they are going bonkers over Indian equities and are buying left-right-center!

Ouch!

What is happening? Who do you think is right?

If this wasn’t confusing enough, let me add some more fuel to the fire.

At the current juncture, there is an equal dosage of both good and bad news for the markets…

Some bad news…

The economy has still not completely recovered out of the crisis. There is now a new Covid strain in UK and the possibility of a second wave. Equity Valuations are on the higher side…

And some good news…

Vaccines are finally out. Covid cases thankfully have significantly come down in India. Profits for large Indian companies have been much better than expected. The banks are indicating that the problem on the credit quality side is not as bad as they expected and are much better provisioned for the impact. Most of the economic indicators are pointing towards a pick-up in growth…

Phew! 

Amidst all these contradictory data points, we need to answer the most important question:

What should you do about your equity exposure? 

Don’t worry. We have got you covered on this.

Given the nuances involved, this is going to be a slightly longer read than usual. But this will give you a clear framework to think through the current scenario and adapt your portfolio accordingly.

Get yourself a strong cup of coffee and let’s dive in.  

Concern No 1: Markets are at an all-time high! Let me SELL!

Markets are at an all-time high. The general market wisdom advises you to “Buy Low and Sell High”. 

Now that markets are high, you should SELL HIGH right? 

We tend to have a different view.

Viewpoint 1: All-time highs are a normal part of long-term equity investing

Let us take a step back.

Equity markets in the long run track earnings growth and Indian equities have historically provided decent long term returns in line with underlying earnings growth.

If we expect Indian entrepreneurs to continue growing their profits as they have in the past, it is logical to expect equity markets to go up over the long run, in line with earnings growth.

For any asset class that is expected to grow over the long run, it is inevitable that there will be several all-time highs during the journey as seen below.

When it comes to gold and real estate we don’t get too worried about all-time highs as we brush it off saying “anyway, in the long run, it will go up”. Similarly, we need to start considering “all-time highs” as a normal and regular part of long term equity markets.

Viewpoint 2: All-time highs don’t mean that markets will crash immediately

Since we anecdotally might have some memories of the recent fall during covid crisis from an all-time high, the natural tendency is to think that all-time highs mean the market is going to crash.

Let us check for actual evidence on how the market has historically performed after an “all-time high”. 

For the last 20 years, we took out the entire period where the Nifty TRI index had hit an “all-time high” level. We then checked for the 1-year and 3-year returns following those “all-time high” levels.

As seen above, the Nifty gave positive returns 73% of the time on a 1-year basis and 86% of the time on a 3-year basis if you had invested during an all-time-high. 

In fact, almost half of the instances were followed by 1-year returns of more than 15%!

This clearly shows that “all-time highs” automatically don’t imply a market fall and in fact, the majority of times, market returns have been positive post an all-time high. 

So past evidence tells us not to worry about all time highs. 

Hmm…OK. But this also leads to your next obvious question:

So if we don’t need to worry about all-time highs what should we actually worry about?

Viewpoint 3: The focus should shift from ‘All Time Highs’ in Index levels to checking for ‘All Time Highs’ in Earnings Growth Cycle, Valuations and Sentiments:

We should be worried when the odds of a large market fall is high. But as we have always told you, predicting the near term markets on a consistent basis is next to impossible.

So how do we know when the odds of a crash are high?

While there is no precise formula to predict the markets, however, we can be ‘better prepared’ if we are aware of where we are in the cycle. Equity markets go through 4 parts of a cycle – Bull, Bubble, Bear, and Deep Value phase. The risk of a severe crash is pretty high when the markets enter the “Bubble” phase. 

Hmm…Ok. But how in the world do we identify a bubble?

Great question. While not a precise science, based on the past study of bubbles, usually a bubble zone is characterized by –

1. Extreme Valuations
2. Top of Earnings Growth Cycle
3. Euphoric Sentiments (high inflows from both FIIs and DIIs, very high past equity returns, a particular theme receiving high inflows, increased demand for IPOs etc)

Thus in our view, all-time highs in index levels are nothing to panic about and the real attention should be on monitoring earnings growth, valuations and sentiments to evaluate where we are in the cycle.

We should be worried about our equity exposure predominantly when we are in a Bubble phase or when valuations have become insane.

Concern No 2: How do I know when to reduce my equity exposure?

Let me take you through our approach.

A bubble essentially means that the equity markets have become insanely expensive with peak earnings growth and euphoric sentiments. So any negative event whenever it hits can cause the markets to crash.

This line of thought argues for a much lower allocation to equities in a bubble than your original allocation. 

But before we jump the gun, here is a statutory warning.

Viewpoint 4: Predicting Bubbles is far easier said than done

Why do we think so?

1. A bubble market can go on for a long time (sometimes several years) and it can become extremely frustrating if you are completely out of the markets
2. Calling a bubble market top is super difficult – even the best have got it wrong!

Sample this…

and here we go again in the recent crash…

To balance both the above factors, we would suggest not reducing the equity allocation below half of your original equity allocation even if you think it is a bubble.

For eg, if your original intended asset allocation was 50%, in case of a bubble market you can reduce it up to 25%. Say your original intended asset allocation was 70%, in case of a bubble market you can reduce it up to 35% and so on. You get the drift.

Why?

HUMILITY – A simple acceptance of the fact that we can be wrong.

Worst case we get our call on the bubble market wrong, we have still built a humility net which is the remaining 50% of the original equity allocation.

Next, we would suggest going underweight in two tranches:

• Underweight Trigger 1: Reduce to 75% or 3/4th of original equity allocation (& move to Dynamic Asset Allocation funds)
• Underweight Trigger 2: Reduce to 50% or 1/2th of original equity allocation (& move to Dynamic Asset Allocation funds)

So far so good. Now comes the most important question

How to decide when to go underweight on equities? When does Trigger 1 and Trigger 2 happen?

Viewpoint 5: Always depend on a logical rule based framework and not on emotions or gut feeling

To find out when Trigger 1 and 2 happen, let us refresh some basics on when would someone want to go underweight equities.

If future returns from equities are going to be low – go underweight. Simple! 

But how do we approximate the equity returns of the future?

For this, let us deconstruct equity returns for their underlying drivers:

Next 5Y Equity Returns = Change in Earnings + Change in Valuation (Price to Earnings multiple) + Dividend Yield

Dividend Yield for the Nifty 50 is usually roughly around 1-1.5%. So in essence if we get a rough sense of earnings growth and valuation change we can roughly estimate the future returns.

Approach for Valuations:

History shows us that valuations don’t stay extremely expensive or cheap for a long time. They eventually move back towards their long term averages. So the extent of valuation deviation from long term averages, can be used as a rough proxy to identify valuation extremes.

Instead of one indicator, we prefer using a mix of valuation indicators and check if all valuation signals point towards the same direction. If the indicators are showing different signals, then it means we need to check for the context involved.

We will be evaluating valuations via factors such as

1. Price to Earnings Ratio
2. Price to Book Ratio
3. Market Cap to GDP Ratio
4. Earnings Yield vs GSec Yield

Based on the evaluation of the above 4 with respect to historical averages, we can take a stance on where the valuations are – 

1. Very High
2. High
3. Moderate
4. Low

Approach for Earnings Growth:

While it is impossible to exactly predict earnings growth, the idea is to find out where we are in the earnings cycle. If you look at history, the equity markets go through periods of strong earnings growth followed by weak earnings growth and again the cycle continues.

So if we can evaluate where we are in the cycle, then we can build a rough expectation around the likely earnings growth environment over the next 5 years.

For this, we will be looking at several factors such as:

• Past Earnings Growth
• ROE Cycle
• Corporate Profits to GDP
• Interest Rates
• Credit Growth
• Capacity Utilization
• Other Factors – Oil Price, Government reforms etc

Based on the evaluation of the above factors with respect to history, we can take a stance on where we are in the earnings growth cycle –

1. Bottom of Earnings Growth Cycle – high odds of above average earnings growth in the next 5 years
2. Middle of Earnings Cycle – high odds of average earnings growth in the next 5 years
3. Top of Earnings Cycle – high odds of below average earnings growth in the next 5 years

Putting all of this together we come up with our framework

Once we evaluate both, here is how this translates into our decision making.

For Trigger 1 (Marginal Underweight to 75% of original equity allocation) to happen, these are the three scenarios

• Scenario 1: VERY HIGH Valuations + Bottom of Earnings Cycle
• Scenario 2: HIGH Valuations + Moderate Earnings Cycle
• Scenario 3: Average Valuations + Top of Earnings Cycle

For Trigger 2 (Underweight i.e reducing to 50% of original equity allocation) to happen, these are the two scenarios

• Scenario 1: HIGH or VERY HIGH Valuations + Top of Earnings Cycle
• Scenario 2: VERY HIGH Valuations + Moderate Earnings Cycle

We also overlay “Sentiment” indicators along with the above framework to drill down to the final view. 

Concern No 3: What does your model indicate now?

We internally track a list of 26 factors to evaluate for these three factors – Valuations, Earnings Growth Cycle and Sentiments (will write a future post to explain this in detail).

Our current view as per our framework:

Viewpoint 6: We are currently in – HIGH VALUATIONS + Bottom of Earnings Cycle + Mixed Sentiments – indicating neutral allocation to equities – i.e as per long term equity allocation

Earnings Growth Cycle: Bottom of Earnings Cycle

1. Last 5Y earnings growth is flat
2. ROE at all-time lows
3. PAT to GDP close to historical lows
4. Credit Growth close to 10Y low
5. Capacity Utilisation close to historical lows
6. Low Oil Prices positive for earnings growth
7. Lower borrowing costs
8. Other factors supporting earnings growth pick up – Initial signs of Economic Recovery, No visible second wave despite an active (and crowded) festival season, Low base, Cost Control measures, Consolidation of market share by larger organized players, Govt reforms (Lower corporate tax, Labour Reforms, PLI Schemes etc), Banking system stress – not as bad as feared, Early signs of pick up in corporate capex and real estate

Valuations: HIGH Valuations – yet to reach ‘VERY HIGH’ valuations

1. PE ratios are optically elevated due to depressed earnings
2. MCAP to GDP is HIGH
3. Price to Book – slightly above long term average
4. Earnings Yield vs GSec Yield – close to long term average
5. The context of low interest rates and high liquidity both globally and in India may keep valuations above long term averages for sometime

Sentiment: Mixed Signals

1. FII Flows are super strong while DII flows are negative – both being very high would have been a concern
2. Past 3-5Y Returns are in the 10-12% CAGR – No signs of euphoria as the past returns at the current juncture is no where close to what investors experienced in the 2003-07 bull markets (45%+ CAGR)
3. IPOs – No signs of euphoria yet. However the no of IPOs are picking up and most of them are getting oversubscribed.
4. Retail Participation in direct stocks – entering euphoric zone

Current View:

• Trigger 2 (i.e UNDERWEIGHT): We don’t see the likelihood of Trigger 2 in the near term, as we are still at the bottom of the earnings growth cycle.

• Trigger 1 (i.e MARGINAL UNDERWEIGHT) can happen if valuations move from ‘HIGH’ to ‘VERY HIGH’. Current valuations are at ‘HIGH’, but yet to cross our in-house valuation thresholds to qualify for ‘VERY HIGH’ valuations. Once this cuts, we will intimate you (if you are a FundsIndia customer) and you can reduce your equity allocation by 1/4th and shift the portion to Dynamic Asset Allocation Funds.

Concern No 4: You financial folks never ask me to sell!

Fair point. 

The reason why we are extra cautious to go underweight is because of three reasons-

1. Your original split between equities and debt already has built in a layer of defence via the debt allocation and takes into account the extent of decline you are willing to tolerate (as per your risk tolerance). The underweight position (whenever we decide to go for it) will be over and above that and hence needs to account for that and will be done only in market extremes.
2. As the markets are generally up over the long term, the odds are against us when we go underweight
3. It is extremely difficult to get the timing right on bubbles as the markets can remain expensive for a long time. Even the best of marquee investors have got it wrong.

That being said, we have shared with you our framework and plan, and yes, it also means we will ask you to go underweight equities if our framework cuts Trigger 1.

Concern No 5: Can you simply tell me what to do in simple english!

Oops! That wasn’t expected. Anyway here we go…

If your financial goal is coming up in the next 3-5 years, it makes perfect sense to immediately reduce/exit your equity exposure.

However, if you don’t need the money for the next 5+ years, here is our suggestion –

1. Rebalance back to Original Asset Allocation
   • If Equity Allocation exceeds originally planned long term equity allocation by more than 5% – cut equity exposure and bring back to the original allocation immediately.
     
2. Build layers of Defense in Equity Portfolio
   • The valuations for value-oriented funds and mid/small cap funds are still reasonable
   • Make sure you are invested in value-oriented funds and mid/small cap funds as a part of the five finger strategy (where we equally allocate across 5 different styles – Value, Quality, Mid/Small Cap, Growth at Reasonable Price and Global
     
3. Wait for TRIGGER 1 Signal (i.e Marginal Underweight):
   • If equity valuations continue to rise and become extremely expensive (we will inform you based on our framework). When that happens, reduce equity allocation to 3/4th  of originally planned long term equity allocation
   • Identify the list of funds from which you will be reducing/exiting and keep the plan ready
   • For underweighting equities, shift from Equities to Dynamic Asset Allocation funds

Concern No 6: What if there is a market fall before Trigger 1?

Just because we have a trigger 1 doesn’t mean the market can’t fall before that. Just like how you can meet with an accident both at driving speeds of 150 km/hour and 40 km/hour, our framework is only meant to try and prepare for the accidents at 150 km/hr. The accidents at 40 km/hr will get addressed via your original asset allocation (remember this is why we have a debt portion).

A 10-15% fall would be considered as normal equity market volatility and requires no major action. However if there is a larger fall, we suggest having a clearly pre-defined plan which can help you take advantage of the fall without panicking.

While we have no idea what the markets will do over the short term, we always want to be prepared to make use of the opportunity if the market falls.

Viewpoint 7: Prepare a ‘What if things go wrong’ plan

Here is how a sample plan looks like:

Pre-decide a portion of your debt allocation to be deployed into equities if in case market corrects

1. If Sensex Falls by ~20% to 38,000 – Move 30% from debt portion (intended for tactical allocation) to equities
2. If Sensex Falls by ~30% to 34,000 – Move 40% from debt portion (intended for tactical allocation) to equities
3. If Sensex Falls by ~40% to 30,000 – Move 40% from debt portion (intended for tactical allocation) to equities

*This is a rough plan and can be adapted to based on individual’s risk profile

Concern No 7: All this makes sense. But this sort of uncertainty is making me extremely uncomfortable and worried.

While our framework is yet to go underweight, however, after seeing the sharp market rally, you might have this sudden urge to sell some portion of equities. 

No worries, welcome to the rest of us.

This is precisely why we always emphasize on an evidence-based approach over emotional investing. So tempting as it may be, stick to your asset allocation as per plan!

That being said, at the end of the day as humans, we all have certain behavioral quirks that are difficult to get over. As with most things in life, the trick is to ‘strike a balance’ and ‘sin a little’… IF REQUIRED

Viewpoint 8: Sin a Little

Instead of reducing equity allocation and shifting to debt, take a mid-path solution by moving into Dynamic Asset Allocation Funds.

If you find yourself getting too anxious or confused about the equity markets, you can start moving a small portion – say 10-20% of your equity allocation into Dynamic Asset Allocation funds.

To reiterate, in our view, sticking to your original asset allocation till our framework indicates trigger 1 or 2, will remain the ideal solution.

However, worst case if you are not able to get over the anxiety and uncertainty regarding equity markets and have this urge to reduce equities, the mid-path solution of using Dynamic Asset Allocation Funds can be a good alternative though it means sinning a little.

This thought process can be summed up in our belief that,

A decent investment plan that you can stick to is far better than a phenomenal investment plan that you give up on.

Summing it up:

We want to reiterate the fact that stepping out of the equity market is extremely difficult and a lot of the best investors have got it wrong. So while we have a framework built to do this, we would want to be humble enough and acknowledge our ability to go wrong.

Thus the underweight decision will be done only for a maximum of upto 50% of equity exposure and that too only in market extremes where three conditions are satisfied –

1. Insane valuation
2. Top of earnings growth cycle
3. Euphoric sentiments.

Further the reduced equity exposure will be shifted to Dynamic Asset Allocation funds and not Debt funds.

At the current juncture, as per our framework, we are in – HIGH VALUATIONS + Bottom of Earnings Cycle + Mixed Sentiments – indicating neutral allocation to equities – i.e as per long term equity allocation

Our Suggested Action Plan:

If your financial goal is coming up in the next 3-5 years, it makes perfect sense to immediately reduce/exit your equity exposure.

However, if you don’t need the money for the next 5+ years, here is the plan

1. Rebalance back to Original Asset Allocation
   • If Equity Allocation exceeds originally planned long term equity allocation by more than 5% – cut equity exposure and bring back to the original allocation immediately
     
2. Build layers of defense in Equity Portfolio
   • The valuations for value-oriented funds and mid/small cap funds are still reasonable
   • Make sure you are invested in value-oriented funds and mid/small cap funds as a part of the five finger strategy (where we equally allocate across 5 different styles – Value, Quality, Mid/Small Cap, Growth at Reasonable Price and Global)
     
3. Wait for TRIGGER 1:
   • Trigger 1 can happen if valuations move from ‘HIGH’ to ‘VERY HIGH’. Current valuations are at ‘HIGH’, but yet to cross our in-house valuation thresholds to qualify for ‘VERY HIGH’ valuations. Once this cuts, we will intimate you (if you are a FundsIndia customer) and you can reduce your equity allocation by 1/4th and shift the portion to Dynamic Asset Allocation funds
   • Please note that when underweighting equities, we will be shifting from Equities to Dynamic Asset Allocation funds and not Debt funds
     
4. If you are still feeling uncomfortable and worried, sin a little and move a portion of your equity (say 10-20%) to Dynamic Asset Allocation funds now