Market P/E Ratio Driving Your Mutual Fund Decisions? Big Mistake!
Aug 27, 2019

Author: Vivek Chaurasia

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Factor-based investing is quite common among investors in developed nations. It is a concept where investors make their investment decision based on a happening of a certain pre-specified rule based factor or an event.

Among various factor-based investing techniques, one that is popular among investors is the market valuation based asset allocation strategy. In this, the investor decides increasing/decreasing the allocation to a particular asset class taking into account its valuations.

Well the strategy is tested and has given fruitful results to many in the past. But can it always yield the desired result is still doubtful. The results may be different if the markets show an irrational behavior, which is quite possible.

A recent conversation around the state of the equity markets and investment opportunity took place between me and my friend Ashish, while travelling to office during peak hours on the local train. Ashish works as a relationship manager with a foreign bank's wealth management arm and we often discuss markets and politics.

Those who travel in Mumbai locals would know how easy it is to interact with people whom you don't know by name, but who are familiar faces you meet almost every day in your hour-long commute.

The first time I interacted with Ashish was last year when markets had collapsed following the IL&FS default that resulted into a deep NBFC crisis. The first question he asked me then was, "Did you lose money in that fund?".

Sitting next to me, Ashish had peeped into my phone screen, when I was glancing through a factsheet of a liquid fund that had lost money due to its exposure in IL&FS.

I said, "No, I didn't. But many investors who had invested their safe money in the fund did lose". Unfortunately, he had recommended some of his clients to invest in that particular liquid fund, which backfired. While he regretted having advised the fund to his clients, I had no consoling words for him as deep down I knew that the recovery wouldn't be easy.

Now coming back to our recent conversation, Ashish has an adverse view on the markets due to gloomy conditions, and he has asked his clients to sit on cash and wait for the right time to enter the markets again.

Timing the market is something that I do not recommend. So here was a contrarian point to debate on. While I prefer the concept of SIP and gradual investing, he strongly advocated investing based on market valuations.

As per his study, the benchmark Nifty-50 index is still overvalued and hence there is a scope for deep correction. So one should currently hold higher allocation to cash and debts and move to equities once the valuations enter their fair zone, something similar to the factor-based investing concept promoted by his company.

Although I do not rule out future volatility, given the trade war between US and China along with many other geopolitical events, waiting for lower levels when the broader markets are already down by over 10% from the peak is like eyeing the end-of-season sale to get a higher discount.

Well markets may sometimes behave irrationally and differently from its history. Don't forget what happened in 2009, when many investors and fund managers sitting on huge cash missed the swift rally.

It is almost impossible to get your timing right every time. Price-to-Earnings ratio (P/E) is a relevant indicator to understand the price attractiveness of the market or a stock. But apart from market P/E ratio or valuations, there are various other factors too that may drive the markets.

At this point in our discussion, I asked...

"What if the markets turn tide suddenly and you miss the opportunity?"

"What if President Trump initiates trade talks with China and calls-off the trade war tomorrow?"

"What if Ms. Sitharaman's presentation on measures to boost Indian economy drives the FPIs back to the Indian markets?"

Not having a clear answer to these, he just shrugged his shoulder and said it would be bad luck.

Are markets in an overvalued zone?

Graph: Nifty 50 P/E vs. Nifty Midcap 100 P/E

overvalued zone

​In terms of valuations, the trail P/E of the Nifty 50 index is now hovering at around 27x level while that of Nifty MidCap 100 index is trending below the 30x mark. Clearly, the valuation in the large cap segment is in an overvalued zone, whereas midcaps are below their average levels, indicating a reasonable entry point in this segment.

After a deep correction in 2018, broader markets had recovered a bit since mid-February 2019, banking on a second term for the Modi-led-NDA government, and even rallied after the exit poll results came in. Moreover, it was expecting to strengthen further post Modi 2.0's full budget on 5th July 2019. However, the markets did not cheer the budgets and tumbled down thus eroding the gains clocked earlier.

The Nifty-50 has posted an absolute loss of over -6% since the budget, whereas the Mid and Small Cap indices have tumbled down and lost about 11% and 13% respectively.

Notably, the FPIs were distraught by the budget proposal, of levying a higher surcharge on individuals having a high taxable income (also referred to as 'super-rich tax'), which even applied to FPIs not registered as companies.

Besides, dismal earnings in some counters also had bearing on the Indian equity markets. Trade tensions between the US-China and the other economies, geopolitical tensions, the slowdown in global growth, the accommodative monetary policy of the central banks in the developed economies also weighed on the market sentiments.

So you see, it is not only the market P/E that has led to a downward movement. There are various other factors too that would drive the markets.

Timing the market is something that is more appropriate for traders rather than investors. If you are an investor having a longer time horizon of over 5 to 7 years, a couple of points here and there should not matter much. It's okay to lose a few battles, if you want to win the war; focus on the long-term benefits rather than short-term deals.

Do not miss the opportunity by waiting on the sidelines in a hunt for a greater bargain. It may or may not come through.

Editor's Note: I believe, this is a perfect opportunity for my FundSelect subscribers to gradually add up equity exposure through some top rated funds available at bargain price.

Besides, this may be the best time to consider well-managed equity funds capable of generating high alpha, and add exposure in them before they move up.

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