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Sensex @ 12,000: What should investors do
Navnit Munav | May 01, 2006
The BSE Sensex has returned over 25 per cent year-to-date and is trading at an all time high. This is on the back of impressive returns of 42 per cent, 13 per cent and 73 per cent respectively, during the last three calendar years.
As the Sensex PE has expanded from 13.6 times in 2002 to almost 22 times (based on trailing earnings) presently, it would not be wrong to say that a one time re-rating of overall market is almost over.
The rally in the market has been very broad-based, encompassing several sectors against previous major bull market of 1999-2000, where it was concentrated in a handful of sectors. The rally has been driven by improved fundamentals of the economy and the corporate sector and powered by liquidity flow from both domestic as well as foreign investors.
Fundamentals remain intact:
Favourable demographics and changing social and cultural fabric, revival of capex cycle and large investments in infrastructure, opportunities in outsourcing, rising disposable income and consumption levels are some of the key themes driving our markets. Most of these 'stories' are very much intact. So far, corporate results have been in line with stock market expectations.
Stock ownership data reveals that Indian public owns less than 15 per cent of the total market cap, while mutual funds own another 2.5 per cent. Low ownership of equities by household investors suggests that large and sustained flow of money into equity market can be expected over the next couple of years.
Favourable tax regime, increased awareness about stock market investing, improvement in market infrastructure and low interest rate regime will 'force' investors towards a larger allocation towards equity market.
Inflows from foreign investors have been beating records for three consecutive years. India has been getting a larger share of the overall "pie" available for emerging markets. Using traditional valuation parameters, Indian markets are relatively overvalued compared to other emerging markets.
Having said that, higher capital productivity, longevity and better visibility of growth prospects, better corporate governance and the variety of investment themes make India a unique value proposition. Large flows towards emerging markets like India is a structural and secular trend and not a flavour of the season.
This is a paradigm shift and India is likely to emerge as a core asset class and no longer a place for small tactical allocation for global investors.
While last year bulk of the foreign money came from Japan, this year it is likely to flow from the Middle East where liquidity is in abundance and the local asset markets are overheated.
Key risks going forward
Key risks for the market would be a "not so conducive" political environment, severe infrastructural constraints, a sustained increase in interest rates globally driving out liquidity, and an increase in the local interest rates that could hamper the growth.
At a time when the market is not pricing in any of the negatives, the ability of our politicians, market participants and promoters to spoil the party should not be underestimated! Any major correction in commodity prices would have negative impact, as a large part of Sensex profits (absolute) still comes from commodity companies.
Crude oil prices ruling above $ 70 is another area of concern. Market would also be watching out for a favourable monsoon. Large supply of paper through IPOs would also limit the upside in secondary market.
FII flows dominate delivery volume and short-term trends in the market and any swings in portfolio flows could lead to sharp volatility in the secondary market. So what should investors do now?
Rebalance asset allocation
In the year 2003, when the ten-year bond yield was at five per cent, earnings yield on Sensex was at 10 per cent (inverse of P/E that was at 10) and most investors were underweight equities and overweight bonds.
It is the reverse now, with one-year bonds trading at 7.5 per cent and Sensex earnings yield at 5.5 per cent, investors are flocking towards equity shunning fixed income products.
Though the longer-term outlook on interest rates is still hazy, high short-term rates offer investors decent returns on a risk-adjusted basis. Investors must now allocate some part of assets to short-term fixed income products.
In equities, focus on alpha
As mentioned earlier there are multiple themes to choose from and with large number of listed companies, India's secondary market is a stock picker's paradise. A large number of IPOs are likely to hit the market over the next few months.
Overall volatility is also likely to be much higher than past year. Since the broad market could be termed as fairly valued, beta (market returns) would be more normalised and generating 'alpha' (excess portfolio returns over index) would be critical.
While, rationalising return expectations, better stock selection through bottom up research, managing risk and containing portfolio volatility should be the focus for investors.The author is chief investment officer - fixed income of Birla Sunlife AMC
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