June 27, 2017

Markets And Performance Cycles Invariably… Do Valuations Matters At All?

Sadique Neelgund

Markets And Performance Cycles Invariably… DoValuations Matters At All?

The Indian stock market, after a brief correction in Nov- Dec 2016 in the aftermath of the de-monetization program, has rallied strongly over the past five months with the Nifty 50 Index posting approx. 18% returns YTD 2017 and the Nifty Midcap 100 Index posting approx. 34% returns YTD 2017. In parallel, the Indian bond market yields have declined and been volatile while liquidity conditions have eased following RBI’s neutral policy stance.  The recent rally in India’s equity markets can be partly attributed to lower bond yields and compression in credit spreads coupled with hugely optimistic expectations of future growth backed by muted oil prices and inflation expectations. Furthermore, with a marked decline in risk aversion, with the US VIX Index hovering in single digits lately post US elections, a strong reflation rally in the US has spilled over driving strong rallies in equity markets in Europe, Japan, and Emerging countries as well.

In this rather cheery backdrop, the valuations of Indian stocks have risen dramatically with the Nifty 50 Trailing PE at 24 and the Nifty Midcap 100 Trailing PE at 29.8 in June 2017.The forward PE multiples are now at higher levels at 18.4 and 20.5 for Nifty 50 Index and Nifty Mid cap100 Index. The current trailing PE valuations are seen at nearly 1.5-2 standard deviations higher than long-term average. Relative to the MSCI EM Index valuation, the Nifty PE is over-valued at this point on a relative basis and nearly 0.75 standard deviations above the longer term averages relative MSCI EM Index valuation.

So do Valuations matter at all?  

Absolutely! Markets and performance cycles invariably have followed what is often referred to as the Iron Law of Valuation, i.e. Equity market returns have been strong in periods following low valuations and conversely equity market returns have been volatile and low and even negative at various investment horizons following periods of high valuations. The data below provides the empirical evidence on the historical performance profile of India’s equity markets based on the Nifty 50 Index performance at across different valuation regimes and ex-post investment horizons.


Source: NSE, Bloomberg; Data period: May 2005 – June 2017

The above data clearly highlights the inverse relationships between equity market valuations and ex-post returns at various horizons.  Similar inverse relationships are seen with the Nifty Midcap 100 Free Float Index and as cited by research articles that cover various global equity markets.

While the longer term outlook for India’s economic growth over the next 3-5 years may be promising, the near-term earnings growth outlook is far from robust to convincingly support the prevailing high valuations levels in the market. Over the next 5-7 years, various sectors of the Indian economy have the potential to grow rapidly, driven by secular mega-growth themes linked to Urban / Rural Consumption, Infrastructure, Rural development and Affordable Housing. But the earnings growth of companies has to commensurately catch-up over the next few quarters else the risks of steep equity valuations could trigger bouts of volatility and market corrections over the medium term.

The above insight prompts fiduciaries and financial advisors to exhibit prudence in the factoring higher current valuations in the overall exposure to equities and especially mid-cap stocks in client portfolios. In this regard, well managed Multi-cap equity funds, balanced funds, and Dynamic asset allocation funds may be suitable vehicles for coping with short-term market volatility while offering calibrated equity exposure and being optimally positioned to capitalize on India’s potential growth opportunities and potential future capital appreciation over the longer term.

Implications for investors – The Winning Trifecta!!

  1. Beware behavioral biases and the siren song of herding:

Many investors typically regularly fall prey to herding and chasing equity returns when markets have trended up sharply and are at high valuations; only to experience sharp losses and disappointing sell-offs in the subsequent holding periods. It also well known that many investors have failed to generate any meaningful returns trying to time the market by trying to rotate in and out of equities in trying to manage their holdings in the face of market volatility and valuation cycles. These twin behavioral errors diminish investor returns and heighten investor regret, leading to poor investment decisions and outcomes.

Successful investors recognize that it is the time in the market that matters most!!  A long enough time horizon in a well-managed equity fund is the only real edge in the favor of the average investor saving for long-term financial goals.

  1. In Praise of Asset Allocation:

 To precisely address these twin behavioral errors of investors and to help investors follow a disciplined investment approach, average retail investors should consider the discipline of sound asset allocation principles with assistance from a qualified financial advisor. Many seminal research studies, such as the

paper entitled “ Determinants of Portfolio Performance “ published by Messrs. Brinson, Hood and Beebower in the Financial Analysts Journal in 1986,  that studied the investment performance of US pension plans and other related research have highlighted that asset allocation is the key driver of long-term investment performance. Other aspects such as market timing and security selection had a much lower contribution to long-term investment performance.

Further, different types of asset classes perform differently from one another during across different time periods. Equities are more volatile asset class but have delivered superior returns over longer periods and would be suitable for wealth creation and beat inflation over the long haul. In contrast, fixed income bonds have lower volatility and are suitable for steady income generation. But as these asset classes have low correlations, they can be suitably combined to develop well-diversified portfolios to deliver solid financial outcomes.

Thus sound asset allocation is the core foundation of a disciplined investment program after a careful consideration of the investors’ investment goals, risk tolerance, time horizon and unique circumstances and with guidance from a qualified financial advisor. A good financial advisor can mitigate your behavioral biases, develop a robust allocation plan and more than assist you in achieving successful investment outcomes!

  1. Implement a diversified portfolio of suitable Mutual funds:

While Asset allocation and notions of diversification may be relatively simple in theory, it is difficult in practice. One feasible and practical approach is to rely on the advice of a qualified financial advisor to implement asset allocation through a diversified portfolio of well-managed equity and debt mutual funds with reasonable expense ratios that are suitably aligned with your risk profile and financial goals. Finally, these investment allocations have to be reviewed every 6 to 12 months and periodically rebalanced based on market valuations with inputs from your financial advisor.

Mutual funds are suitable investment vehicles for retail investors offering various solutions while leveraging the investment expertise of professionals. Furthermore, Systematic Investment Plans (SIPs) in Mutual funds also give investors the opportunity to benefit from rupee cost averaging and help ride out the ebb and flow of markets and follow a disciplined long-term approach to wealth creation.  “Mutual funds Sahi Hai” is the mantra!

In specific, Balanced Funds, Muti-cap equity funds and select Short term and Medium term Debt funds are suitable mutual fund categories for investments over next 3-5 year horizon.

To conclude, we can all draw lessons from the insightful Rabbi Talmud who exhorted many ages ago and said: “Let every man divide his wealth into three parts and invest a third in land, a third in business, and a third let him keep in reserve.” – Talmud Circa 1200 B.C – 500 A.D. Diversified mutual fund investments based on sound asset allocation can help mitigate investment risks and deliver superior risk-adjusted returns and thus paves the way for successful financial outcomes over the long haul. Happy Investing!


The views contained herein are the independent views of the author and are not to be taken as an advice or recommendation to buy or sell any investment or interest thereto. Diversification does not guarantee investment returns and does not eliminate the risk of loss. The views and strategies described may not be suitable for all investors.

The information contained in this document does not constitute an offer to sell, or a solicitation of an offer to buy any security, investment product or service.  Investment involves risk. Past performance is not indicative of future performance and investors may not get back the full amount invested.

As an investor, you are advised to conduct your own verification and consult your own financial and tax advisor before investing. The Sponsor, Trustee, AMC, Mutual Fund, their directors, officers or their employees shall not be liable in any way for any direct, indirect, special, incidental, consequential, punitive or exemplary damages arising out of the information contained in this article.

Mutual Fund investments are subject to market risks, read all scheme related documents carefully.

Leave a Reply

Your email address will not be published. Required fields are marked *