Over the past few days I have heard much about not being out there with my recommendations and stock market outlook. This is true. I have been very passive over the last few weeks. This is in stark contrast to how I usually go about my affairs.

Part of the reason why I have not been around much has to do with meeting a record number of new clients and portfolio development for different client needs. Let me not get into what I recommended at the beginning of this year but suffice to say that 2018 so far has been one of the best years for us. Success then has its own kind of logic. Potentials of new client acquisitions have left me little time to write about my views on the market. This last weekend however, I decided to spend some time writing and doing what I used to do a lot more until a few years back.

For starters, despite very robust earnings, markets remain overvalued. Mid and small caps are in particular absolute nuts!! My sense however is that investors will keep burning fingers by averaging their overvalued purchases in this zone, much money will be thrown in here. Banking and NBFCs will continue to do well but will be the frontrunners in a correction whenever that happens. Any such correction however will be short lived and will be followed by a sharp recovery.

 

Stocks: Stay Specific

The last big change I made to my stocks portfolio was towards the end of last calendar year when I moved a lot of money into IT and Pharma.

This was and remains no brainer. I was and remain long on both these sectors. Any correction as I mentioned will be followed by a very obvious and quick recovery. On IT, I am not going to talk about legacy vs digital vs U.S. vs what not. All I can say is that over the next 5-10 years, some pretty insane developments will take place in IT space. Everything including the very industry I work in will get taken over by technology. I remain mightily amused by those suggesting a slowdown in IT sector in the coming decade.  On pharma, it is simply undervalued and this will correct at some point. In the last few months many fund houses have launched a pharma specific strategy. As these funds grow in size, it is natural for cash to flow into pharma stocks which for some reason continue to get hammerred way beyond they should have bee.

Fixed Income: This will be key to alpha

In addition to taking exposure to select sectors of the market, I am a big believer that bonds as an asset class will do well over the next 2-3 years.

That said, I have noticed that if I tell a regular investor to take a 50% exposure in stocks only in IT and Pharma and put the balance in fixed income strategies, it just doesn’t excite them. If you must do something outside of this zone, be very stock specific and preparre to  hold on to what you buy for least 5 years. I suggest going short in some sectors with about 10% of your portfolio for which you should ideally get a heartless trader on your side. If there ever was a need to do portfolio construction it is now and if you cant do it, then believe me – an 8.2% – AAA FD is the best way to go right now.

Coming to fixed income strategies, lets see what markets have deliverd over the past 5 years. Also keep an eye on the trailing PE valuation of the Nifty.

Year Nifty Level Change Nifty PE
2014 7,459.60 20.12
2015 8,360.55 12% 23.17
2016 8,521.05 2% 23.37
2017 9,816.10 15% 24.98
2018 11,043.45 13% 27.20
AVERAGE RETURN 10%  

Try to answer these 2 questions for yourself:

How many more years can the markets deliver these kinds of positive returns? Will markets fall 8-10% at some point over the next 3 years?

Assume that in the next 3 years markets continue to deliver an average return of 10%. In fact lets assume that the next 3 years are even better than the previous 5, and lets bump up the return by 2%, taking the next 3 year average return to 12%, which is followed by a 10% correction, then this is how your returns and portfolio will look like (of course, a good fund or portfolio should outperform this 12% number, but by how much?):

Current Corpus Rs. 100
Returns in 3 years @ 12% compounding annually Rs. 140
Value post 10% correction in 4th Year Rs. 126


Here’s a different math – Rs. 100 deposit growing at an average 8.2% p.a. will grow to Rs. 138 in 4 years. Now think again, do you still want to invest in stocks at market PE of 27? 

Certainly, I am not asking anyone to put all your money in fixed deposits and retire. No one every became rich by investing in fixed deposits. There has to be tactical allocation of capital. Sure, in between you will feel cheated if markets move higher aggressively, lets say 15% over the next 1 year. But set your eyes on 3+ years and by all means stay invested in stocks, but the right stocks!…. and avoid doing investments and SIPs blindly as many seem to be doing these days.

Keep in mind that equities deliver poor returns if you invest in them when the markets are overvalued—as they are now (trading at valuation of 27).

PE-Ratio

I am not encouraging that you invest in debt funds. At such high valuations, investors are required to adopt rule based allocation to equities. For example, you can structure your equity rule in such a way that your exposure to equities goes down to say 35% by the time the P/E is 24 and further down to 15% by the time the P/E is 27. This too in stocks which are way below this market wide number. A lot of money will then be made and I have no doubts on this.

This will ensure that your profits are booked at regular intervals and that you have liquidity available when better opportunities present at lower levels. The opposite rule will apply when the markets are falling.

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I have updated my top stock and mutual fund ideas for the next 12 months in this section – https://www.sanasecurities.com/street-sounds/

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