By: Tavaga Research

Sensex, the flagship index of the Bombay Stock Exchange, closed at 25,981 points on March 23^rd, two days before the COVID-19-induced nationwide lockdown was imposed. Now, almost eight months after the lockdown was first imposed, the benchmark indices are pummeling their all-time highs, session after session. The markets began the Hindu calendar year Samvat 2077 on a high, with both the Sensex and the Nifty 50 indices, closing at their all-time highs of 43,637 and 12,770 respectively, during the special one-hour Muhurat trading session on Diwali.

The strong performance reported by some of the country’s biggest companies is, in part, driving the optimism in the markets. For instance, 35, of the 50 companies that make up the Nifty 50 index, beat or matched analyst estimates for the quarter ended September 2020. In addition, several high-frequency indicators point to an economy mending faster than expected.

In addition, several high-frequency indicators point to an economy mending faster than expected. Monthly goods and services tax collection crossed the INR 1 trillion mark in October; industrial production set foot in the positive territory in the month of September, having been in contraction for six months consecutively.

The economic activity index released by the RBI for the month of November indicates that the contraction in GDP for the second quarter of the current financial year would be lower at -8.6 percent compared to an earlier estimate of -9.8 percent. Moody’s, a rating agency, revised India’s GDP forecast for the calendar year 2020 from -9.6 percent contraction projected earlier to -8.9 percent.

All these developments happening in the backdrop of positive news on the vaccine front bodes well for the overall economy and for the markets in turn.

Factors fuelling the markets

India’s market capitalization-to-GDP ratio has reached a level of 88%, the highest in 12 quarters and nearly 12 percent more expensive than the historical average. What’s more, the market is also trading at valuations close to their peak when measured in price to book (P/B) and price to earnings multiples (P/E).

There are several factors fuelling these high valuations. Since markets are first and foremost forward-looking vehicles, they focus on the future, not the present or the past. The developments mentioned above points to an economic outlook that is brighter than was expected by most, helped by the festival of lights. This assists because the consumers can set off the virtuous cycle of demand, employment, and growth, without fearing about the uncertainties that this pandemic has in store for them.

Furthermore, the surplus liquidity traversing the global markets aided by aggressive monetary and fiscal expansion by major developed economies is the other major factor driving these valuations. The emerging markets (EM), such as India, are usually the biggest beneficiaries of such fiscal stimulus and quantitative easing (QE) measures, given that the investors are always on the look for higher returns offered by these EM. For instance, foreign institutional investors (FII) have brought in around INR 1,22,000 crores, since April.

Another major factor that is fuelling such valuations is the level of the interest rates; this is perhaps the most significant factor. The price of a stock must be related to the benefits we expect to receive from holding it. Since the stocks are ultimately priced by discounting a company’s future earnings, there are two ways to increase the price of a stock: higher future earnings or lower interest rates. Therefore, a low-interest rate translates to high stock price and vice versa.

What should be the action point for equity investors?

The recent announcements by Moderna and Pfizer on the effectiveness of their respective vaccines is a big positive for the equity markets. This reduces the likelihood of a further lockdown being contemplated in the political circles, amid the resurgence of coronavirus cases, both in the US and Europe.

In addition, President-Elect Biden is expected to sign a further stimulus package to protect consumer’s income and sustain the economic recovery, although the prospects of a huge stimulus have diminished drastically.

Consumers, who have been holding back their expenditures, fearing the uncertainty surrounding their income, can now loosen their purse strings bringing consumer expenditure, a critical component of the GDP, back to life.

These developments have a positive bearing on the earning potential of the firms, which in turn impacts their planned capital expenditure going forward. This has the potential to propel the markets to newer heights. Although, the high valuations at which the markets are currently trading, is a concern.

Overall, the outlook remains positive for equities. Investors looking to invest in the long term can continue exploring high-quality large-cap growth stocks. They can also explore investment funds such as exchange-traded funds (ETFs) that provide exposure to the underlying indexes such as the Sensex and the Nifty 50. For instance, the SBI ETF Nifty 50 has returned over 12 percent (CAGR) since November 2015.

Performance of SBI Nifty 50 ETF

Investing in individual stocks at such high valuations won’t be recommended. However, investors can opt for the staggered lumpsum mode, wherein, lumpsum money can be invested at every dip/correction. Booking profit in ETFs and stocks is subjective in nature, and the gains must be only realized if all the desired financial goals have been achieved.

What’s in it for equity Mutual Fund investors?

Investors invested in equity mutual funds can exit their portfolio at a profit, given that the markets are at an all-time high, and invest those funds in high-quality ETFs or index mutual funds.

Mutual funds have a higher expense ratio compared to ETFs and they have consistently underperformed their benchmark indices, and hence, investors should consider exiting their positions from mutual funds, especially, the regular ones who have an expense ratio of up to 2 percent.

What should the bond investors do?

The debt market has been benign, with October being another positive month for Indian bonds. The yield curve shifted down by 10-20 basis points (bps). The yields on the 10-year government bond declined from 6.02 percent in September to 5.88 percent in October a 14 basis point (bps) reduction.

Declining Bond Yields

The downshift was triggered by a reasonably accommodative stance by the RBI on the willingness to look beyond the recent spike in headline CPI inflation. They also communicated their readiness to further cut the policy rates, if the need arises.

Usually, fiscal measures announced by the government, such as the last week’s Stimulus 3.0, draws a sharp reaction from the bond markets. The yields generally spike, leading to a crash in the price of the bonds. But this time around, the yields hardly moved, in part supported by the RBI’s open market operations (OMOs) and their commitment to keeping the yields and therefore the interest rates low.

This, therefore, has important implications, since debt is an essential part of a portfolio for investors, big or small, for their income-generating characteristics and their low correlation to equities.

Investors looking to invest in bonds can do so through bond ETFs such as the Gilt ETF offered by Nippon India AMC or consider investing in sovereign debt mutual funds, such as gilt mutual funds or constant maturity funds.

Moreover, it bodes well for investors to invest large sums of money in gilt funds when the interest rates are high (NAVs go down when the interest rate and yields go up).

Outlook for Gold

Again, on the news of the vaccine, the gold has been on a downward trajectory. Given an expectation of a lower stimulus and therefore a lower slide in the dollar value, the gold is expected to remain under pressure. Also, the demand for gold as a safe asset is going to fizzle out, given the vaccine holds its promise. Although it offers protection against inflation and currency debasement, the return on gold hasn’t been attractive except for years in which there has been stress in the real economy.

High valuations on stocks limit their upside potential, driving investors to other avenues for return. This coupled with low yields (high prices) environment being observed currently on bonds, steers investors towards assets such as gold.

A well-known fact is that gold and equities are negatively correlated, so a positive development for equities has the opposite impact on the bonds. These considerations could merit 10-15 per cent of the portfolio in gold. But investors should be smart enough to invest in a staggered manner, instead of investing it as a lump sum.

Investors looking for gold investments can do so through gold ETFs, which saves them from the hassle of storing and safeguarding the yellow metal.

Diversification is an important tool to achieve financial goals. An appropriate asset allocation model must be followed by an investor, especially, when the equity markets are at all-time highs, the bond yields are at their lows, and the gold is also hovering around its highs.

Always consult an unbiased financial advisor before investing in stock markets!

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