The stock market has rallied significantly. Is the magnitude justified by fundamentals?
Several factors contributed to this rally. First, the economic recovery has been sharper than initially expected. We are already at pre-covid levels in several areas and others are getting there. Due to global recovery, we are seeing pick up in exports. Right initiatives from the government— policy measures, infra focus, push on divestment, etc—have helped improve market sentiments. These things play out in the medium to long term and auger well for the market.
What about the valuations after this big rally?
While the overall economic prognosis is looking good, valuations have gone beyond historical long term averages. That is a concern. Unbridled valuation in some pockets is another concern. As of now, mid- and small-caps are trading at a premium to large-caps, which is not a sustainable situation, and that is also makes us wary. It is not healthy for a market to have one way run for a long period of time. Since periodic corrections bring some rationality, you don’t see sharp corrections in such a scenario. Ideally, there should be short-term corrections and markets should consolidate. That not happening now is one concern.
What is your portfolio strategy now?
Since valuation is disconcerting, we are cautious in the short-term. We prefer sticking to large-caps in this kind of a market. Since mid-caps are more expensive in most sectors, I will be happier to buy a large-cap with lower valuation which could withstand shocks better in a falling market. We also prefer stocks which won’t fall as much as the market when correction comes.
Are you getting into defensive sectors?
No, when I say cautious, I mean following a more balanced portfolio approach. In every sector, there will be stocks with relatively lower valuations and we will be buying that. Instead of concentrating the portfolio in just defensive or cyclical sectors, we prefer to maintain a more balanced portfolio with exposure to all sectors.
Which sectors are you overweight or underweight on now?
Among cyclical sectors we like domestic financials. That sector is expected to do well once credit growth comes back. They are also better placed in terms of valuations. We believe that there is some play on the capital goods space. We also remain overweight on cement. From the defensive sectors, we are happy playing the IT sector, which has a longer runway for growth. Pharma looks interesting due to its recent underperformance. We are selectively underweight in auto, in metal due to current high prices, and in some consumer names.
Being a life insurance company, we are focussed on the longer term and we typically manage a more balanced portfolio. We never bias our portfolio to one single theme or sector and we never go too overweight or underweight in any sector. Even within sectors we are underweight, we will have exposure to some of the stocks from there.
With market valuations high, what are the headwinds that can result in a correction?
Inflation is a big concern, pretty much across the globe, and investors need to keep a close eye on it. The recent commodity price spike is due to supply bottlenecks and the market perceives it as transitory. While supply bottlenecks are the main reasons, they are not the only reasons. While the domestic headline inflation has come down, the core inflation is still sticky around 5%.
Crude oil is at $85. Is that transitory?
It is too early to call it transitory, because we are in the middle of an energy transition. Considering the supply side restrictions, different parts of the world will react to the situation differently. There will be a challenge to a smooth transition. While the incremental investment in coal and crude is low, corresponding high investments are not happening in clean energy sources. The market has to watch whether this energy transition will be smooth or rough over the next 5-7 years. If the transition is not smooth, some older fuels may go up in between.
Will tapering impact the market?
Considering the signals coming from the US Fed, tapering may happen during November or December. I believe this will not have a large impact. Having said that, just writing it off and assuming it will not have any impact is also not right. Once the Fed starts tapering, it will reduce incremental money flows and markets do tend to react to that.
What are the other concerns?
The other concern is more fundamental. Over the past 12 months, we have seen earnings upgrade cycles playing out; but we did not see major earnings upgrades during the June quarter. If there are no earnings upgrades in the September quarter, it will show that the earnings upgrade cycle is getting over. This will be a little bit concerning for a market’s valuation perspective and one has to be cautious. While it is easier to justify higher valuation in periods of earnings upgrades, it is not possible during periods of stable earnings growth.
Any chance of earnings downgrades?
I don’t see any earnings downgrades happening in the near future. However, investors should watch the space closely because margin pressure is becoming prominent and it may happen across consumer facing industries.
Market valuations are high in relative terms. How big a concern is that?
The Indian market is trading at a significant premium to other emerging markets. We are deviating from the long term average and that is a concern. However, things are slightly different now. We had a slew of IPOs. Some have started listing and that is driving a lot of flows. Anecdotal evidence points at the chance of money moving from Chinese internet stocks to Indian internet stocks. All put together, Indian market has got a large share of inflows. This is not sustainable forever. I don’t know when this will stop. But the market will correct when it finally happens.
