Prime Strategies: Is it time for profit booking?

These are the worst of times for businesses. But the equity markets think otherwise.  Dancing to a tune that only the stock market hears, the Nifty has clocked many firsts in the last few months :

• The Nifty’s official price earnings ratio (P/E) has reached an all-time high at 32 times.
• The April 2020 bounce saw the highest calendar month returns in a decade.
• The rolling 3-month returns in last three months are the highest over the decade.

This, when the GDP growth is a at a decadal low,  industrial production has slumped and corporate earnings are in a slump with little visibility. Should you rejoice at this divergence or view this with caution?  

 Book profits

With a 49% return from the March 23 low, the Nifty is at lofty levels, accompanied by a  sharp rally in mid and small-cap stocks.

We think the V-shaped recovery witnessed in the market post the fall in March 2020 is unlikely to be justified  by a similar recovery in corporate earnings nor in the macro scenario in the next year or two. Market valuations currently are steeper than in previous bull market peaks like 2008.

While earnings visibility is low and valuations are high, there’s also a high degree of  complacency in the market that the rally will continue, as signaled by the behavior of the India VIX and rising  retail participation in cash market with a flurry of new demat account openings.

For these reasons, we think it is good to take some money off the table.

Let us explain the above reasons in detail.

Uncomfortable valuations

While the Nifty’s official PE based on standalone earnings of the underlying companies is at a record high, how does the PE look based on consolidated forward earnings? Well, consensus estimates of analysts place the Nifty 50’s consolidated earnings at a flat (compared with FY20), Rs 543 for FY-21. That takes it to a forward P/E ratio of 20.7 times Nifty’s current level of 11,372.

We do know that the Nifty’s consolidated quarterly earnings for June-20 has crashed by half over a year ago and is likely to continue a declining path for at least the next 2 quarters. Hence, by hoping for   flat earnings for the Nifty by the fiscal year-end, the markets are stretching it a bit in  in our view.

If we stay clear of the standalone/consolidated controversy and calculate the Nifty PE by taking  the total market cap of the Nifty companies and dividing it by the  trailing consolidated 12-month profits, the PE still is at a pricey  32 times.

 Even if analyst estimates of a 25% bounce back in earnings for FY-22 are met,  valuations would not correct much.  To this extent, the lofty valuations offer little comfort.  

Not similar to 2008

Nifty valuations seldom reach 30 plus levels in the early stages of a bull market. 

So how do we know if the market has not already made a bottom in March 2020? What if we are in a new bull phase already? Well, valuations trends from the previous corrections tell us that Nifty valuations seldom reach 30 plus levels in the early stages of a bull market.

Let’s take stock of the Nifty’s trailing consolidated P/E during the previous market peak and correction thereafter in 2008-09 (using MCap divided by trailing 12-month consolidated profits).

• The consolidated trailing P/E of the top 50 companies around the peak of January 2008 stood at 24.7 times.
• By June 2008, when the market was six months into correction, the Nifty50 companies’ P/E was at 14 times and  went on to touch even lower levels from there.
•  The consolidated trailing PE stood at just 10.7 times in the March 2009 lows!

Interestingly, at the recent low on March 23, 2020 (which didn’t last very long)  the consolidated P/E did touch 15 times. But the falling earnings after that, combined with rising stock prices  has made  the Nifty 50 get very expensive very quickly. By June 2020, the P/E had bounced to 26 times and is now at 32 times in August 2020.

Contrast this with 2009: by August 2009, when the market was recovering from its March 2009 lows, the Nifty consolidated trailing P/E was still at 18 times!

The point that we are trying to make is simple:

• The recent rebound has boosted the Nifty PE too far and too fast
• Much of the dent to corporate profits from the Covid impact is ahead of us and the earnings fall this time around may be much higher and longer lasting than in 2008-09
• While there was a clear road to earnings recovery by 2009-10, the present story is vastly different, clouded by the Covid -19 impact on incomes and job prospects.
• Barring a few sectors like chemicals, pharma or FMCG, the earnings forecasts for most sectors for India are up in the air. Lower funds for the govt. to spend, lower surplus for companies to invest  and less money in the hands of consumers adds up to a hazy earnings outlook

Why the rally then?

Markets appear to be making the best of the situation. Let us explain with a couple of points:

Given that the direction of global liquidity is notoriously difficult to predict and that retail investors joining this rally are mostly chasing quick returns, it’s hard to say when the music will stop, popping this bubble.  

Global liquidity gusher: Stock prices over the past decade have been driven more by global liquidity than fundamentals. In this context, continued stimulus measures by the US Fed and record low interest rates globally are offering an even bigger prop to stock valuations worldwide, post Covid. Liquidity flowing into Indian stocks by virtue of FPI flows and domestic retail investors punting on small and mid-caps have also helped. But given that the direction of global liquidity is notoriously difficult to predict and that retail investors joining this rally are mostly chasing quick returns, it’s hard to say when the music will stop, popping this bubble. 

Optimism about earnings revival: The market appears to be taking positive cues from the silver linings in the recent earnings numbers – signs of rural demand holding up, consumer staples normalizing and Nifty operating margins holding up. While the Nifty firms’ consolidated sales fell 25% Y-o-Y and earnings tumbled 51%, ex-banking and finance companies, operating profit margins expanded by over a percentage point to 15.7%, thanks to aggressive cost cutting measures.  The market appears to have given a thumbs-up for this with a continuing rally post June earnings.

Mid and small-caps are rebounding from a long correction: While the Nifty 50 may have barely corrected before this rally, mid and small caps did go through a prolonged correction. From early January 2018 to their March 2020 lows, the Nifty Midcap150 and the Nifty Smallcap 250 have seen a 45% and 61% fall respectively; sliding throughout the 2-year period. Remember there was just a full 1 year of rally and 3 years of steady fall.

 The recent rebound in mid and smallcaps can therefore be seen as a relief rally.

• From the lows in March 2020, 50% or 250 of the Nifty 500 companies have rallied over 50%. This has a mix of large, mid, and small-cap stocks.
• Taking this 250 as a universe, if we look at the market-cap makeup, 3 in 5 companies (60% of companies) were below the market cap of Rs 10,000 crore. In other words, the companies that rallied swiftly are from the mid and small-cap space.

The market has not  rewarded the mid and small-cap segment without reason. After a prolonged downturn, markets found these segments better valued, with better earnings prospects.  Companies in Nifty Midcap 150, for example, managed to contain their June quarter earnings fall to 13% (for 115 companies for which results were available).

But what you need to take note is that mid and small-cap earnings have remained lack lustre since their 2017 peak. So that meant that they were able to showcase results in June 2020 on a lower base compared with their large cap peers who did not have a low base advantage.

Even assuming that this is the beginning of a broad-based rally – with mid and small-caps leading the move, the question is – which sectors to add to your portfolio, to participate in it. Equity markets have demonstrated many times in the past that every new bull market  is driven by a new set of themes and ideas.

The infrastructure and real estate theme died post 2008. The next decade saw very few stocks in the cyclical space participate save for the upswing in realty, basic materials, metals, and telecom in 2017 alone.

With Covid 19 all set to either completely upend traditional consumption patterns, policy priorities and ways of doing business, it appears quite likely that many sectors leading the previous bull market may see consolidation or see valuation derating giving way to a new set of players. Unless your portfolio is already positioned to ride this change, booking profits in your older positions does make sense.  

Taking other cues for profit booking

If the earnings and valuation make a case for profit booking, there are also other behavioural cues from the market that are making us  cautious about this rally.

Bull markets are founded in scepticism and die on complacency. 

Fear gauge at a low: Bull markets are founded in scepticism and die on complacency. The India Vix (Volatility index) or fear gauge is a good indicator of the extent of fear or greed in the market. Today, the index is a study in complacency.   This index captures the degree of volatility that traders expect in the market over the next 30 days. The low volatility in India Vix (graph below) show market perception that volatility is not expected to pick up anytime soon.

To put it simply,  there is little fear in the market. And that is not a good thing in these times, especially if the sentiment is driven by retail.

Non-institutional volumes surge: According to a report by Motilal Oswal Securities, the average daily cash volumes in the exchanges for July’20 were at Rs 622 billion, double that of same month 2 years ago and 78% more than a year ago. Importantly, non-institutional participants accounted for 72% of such volumes – the highest since August 2009!  That essentially means a lot of your peers out there are furiously trading! But not smarter folks like  mutual funds or domestic institutions.

Domestic institutions selling: Mutual funds, which have been supporting the market for the last couple of years have been net sellers through July and August till date. While lower inflows from investors and redemption pressures could be one reason for this, profit taking or staying cautious could well be the other reason.

One indicator of what MF managers think of valuations is their equity allocation in  dynamic asset allocation/balanced advantage funds. The equity allocations of such funds, – which take dynamic calls based on equity markets – have fallen from 65% in May 2020 to 55% in July 2020, suggesting that funds may be getting more cautious or hedging their equity positions based on  higher valuations. .

What to do

Much of this article has suggested that market has raced ahead of  fundamentals and there is not much sign of fundamentals catching up soon. But do remember JM Keynes’ words – markets can remain irrational longer than you can remain solvent.

In the present scenario, markets can remain lofty  until fundamentals catch up or do a U-turn to align with fundamentals. We do not pretend to know how the catch up will happen. It is for this reason that taking some money off the table is prudent – but exiting your equity exposures fully or even substantially is not.

For you, the simple ways to rebalance would be as follows:

• Look at your own asset allocation. If your equity portion swelled from your original comfortable allocation decided in more normal markets, book profits and sweep some money into low-risk liquid/ultra-short options or even short-term bank deposits. These can be  redeployed when the opportunity arises.
• If you have an exceedingly high equity allocation (over 75%) in a portfolio where your goal is less than 3 years away, book substantial profits to avoid being short changed at the nth hour by a correction  
• If you hold mid and small-cap funds, simply rebalance them to your original allocation (say you had 20% 10 years ago, and it is now 25%) as a part of your overall equity rebalancing.
• DO NOT try to stop SIPs and try and time them. That’s not the idea of SIPs.
• If you hold mid and small-cap stocks, reduce your allocation to stocks based on valuations. Stocks that have sharply run up in the past 5 months and are stiff premiums to the Nifty must be your main choice for profit taking. Unless you are adept at stock picks, do not try to pick small-cap stocks based on recent  returns. You never know what stocks the next  rally will include, markets can be ruthless and throw the old favourites by the wayside.

(You can read our detailed write-up on rebalancing here: https://www.primeinvestor.in/how-to-rebalance-your-portfolio/)

If you are asking us when to redeploy the money, we don’t have an answer now as it is never easy to identify companies that survive this phase and make it to the next bull run. If we must throw darts, it is best done when  valuations favour it.