Rebalance your portfolio in case it has become overweight on equities vis-a-vis your strategic asset allocation.
The Nifty closed above 20,000 for the first time on September 13 and has climbed further since then.
The mid- and small-cap indexes, too, appear to be on steroids, having outperformed the large-cap index by a wide margin. Investors must avoid the extremes of greed and fear in such an environment.
The Nifty consolidated for about 18 months before it began its ascent over the past six months. During the period of consolidation, foreign institutional investor (FII) flows had turned negative.
Nonetheless, the market remained stable and did not correct heavily because FII outflows were balanced by inflows from domestic institutional investors (DII). Meanwhile, earnings continued to grow during this period.
Around six months ago, FII flows turned positive. According to Bharat Lahoti, co-head, hybrid and solutions, Edelweiss Mutual Fund, "FIIs preferring India within the emerging markets basket is a key factor behind the Nifty scaling a new high."
Currently, positive flows from both FIIs and DIIs are driving the markets to higher levels.
"The earnings growth trajectory is also reasonable with visibility over growth in the medium term. The United States, Chinese and European economies are all mired in trouble. This has made India all the more attractive as an investment destination," says Arun Kumar, head of research, Fundsindia.com.
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Mid, small caps lead
During the 18-month period when the Nifty consolidated, the mid- and small-cap segment remained stagnant.
From May 2023, small and mid-cap funds witnessed strong inflows. As mutual funds invested the money they received (along with direct investments by retail investors), this market segment rallied strongly.
The preference for the mid- and small-cap segment is due to investor sentiment turning very optimistic.
"Investors are willing to take higher risk. This is borne out by increased demat account openings, and by the large number of initial public offerings (IPOs) that are preparing to hit the markets," says Kumar.
Large-cap funds, on the other hand, have witnessed outflows (indicating a shift towards riskier assets).
Optically, the three-year returns of mid and small-cap funds appear strong currently, due to the starting point being the lows of 2020.
Earnings growth trajectory over the medium term appears sound for these categories as well.
Lastly, the small-cap category especially is not very large, so inflows tend to have a greater impact.
Broadly, the consensus view is that Nifty earnings are likely to grow 15 to 18 per cent over the next two to three years.
Valuations in the Indian market are at above historical averages. However, the current valuations have to be viewed in context.
"We are in the midst of a cyclical recovery, with the Nifty's return on equity (RoE) rising above the 15 per cent mark after a decade.
"When this is looked at in the context of valuation of P/BV at 3x, which is closer to the historical average, it does not appear demanding," says Lahoti.
Adds Kumar: "India's valuations also need to be viewed against the backdrop of its reasonably good earnings growth outlook vis-a-vis problems in all the major global economies."
While large-cap valuations are higher than historical averages, investors need not be overly concerned.
"The mid and small-cap segment appears more expensive in terms of valuation compared to large-cap," says Kumar.
According to Chandraprakash Padiyar, senior fund manager, Tata Mutual Fund, "Valuations in pockets across market capitalisation have started to look pricey. Returns have got preponed from the future to now and one needs to be more selective in stock picking to generate performance going ahead."
The key risks could come from unexpected global developments, which could trigger FII outflows.
"Weaker monsoon, rising crude, sticky bond yields and demand recovery in festive season need to be monitored from the risk perspective," says Lahoti.
Crude oil is at $92 per barrel currently. Any further increase in its price would be adverse news for the market.
"High crude price has the potential to delay the government's capex plans, tighten liquidity in the system, and cause currency depreciation against the US dollar, thereby impacting earnings and market valuations," says Padiyar.
However, with China slowing down, there is hope that crude prices may not strengthen further.
Another risk could arise from potential surprises in the outcome of the general election.
The market expects the current government to be returned and reforms to continue. It could react negatively if things pan out differently.
Current valuations are especially high in the mid- and small-cap segment. Any negative news could trigger a correction there.
"If risks arise or inflows dampen, mid and small caps would be more vulnerable," says Kumar.
However, strong domestic flows are expected to provide a cushion against a steep correction.
What should investors do
While valuations are on the higher side, the bigger question an equity investor should seek to answer is whether earnings will continue to grow over the next three to five years.
"The fundamentals appear to be in place to support earnings growth," says Kumar.
Investors should ideally have entered equity mutual funds with a five-seven-year view. They should stick to it now.
Experts say now is not the time to turn dramatically aggressive or overly cautious in equity allocation.
"Investors should neither significantly increase nor decrease their equity exposure compared to their original allocation," says Kumar.
Investors need to manage their emotions during this period and not get carried away by either extreme greed or extreme fear, depending on whether they believe markets are likely to go up much more or crash.
"Look at valuation data carefully, and do not get carried away by either of these two emotions. And rebalance your portfolio in case it has become overweight on equities vis-a-vis your strategic asset allocation," says Vishal Dhawan, chief financial planner, Plan Ahead Wealth Advisors.
Experts say investors should avoid investing aggressively in small-cap funds as their valuations don't provide an adequate margin of safety.
"Above 15-20 per cent allocation to small-cap funds would be risky at this point," says Kumar.
SIP (Systematic Investment Plan) investors should not worry too much as the cost of their purchases will average out over time. But those considering aggressive lump sum investments in small-cap funds based on past performance should reconsider.
Instead, they should spread their investments over the next 12 to 18 months.
Lahoti warns against investors underestimating the risks in the microcap stocks.
"History suggests that the rate of failure is higher in that category," he says.
Normally, rebalancing the portfolio once a year is sufficient. But the market's run-up could have caused you to become significantly overweight on equities.
If the deviation from the original equity allocation is less than 5 percentage points, don't rebalance.
If it is between 5 and 10 percentage points, and your regular rebalancing date is within the next two to three months, you can wait until then. But if the deviation is above 10 percentage points, you should rebalance immediately.
Since selling equities and moving money to debt will create a tax liability. Investors should try to rebalance their portfolios by directing more of their future flows into debt.
Mistakes to avoid
Procrastination in deploying new money: When markets are at an all-time high, people are reluctant to deploy new money.
However, waiting for the markets to correct to a level one deems appropriate can be problematic, as the market may not come down to those levels at all.
Or even if it falls, the news could be so negative at that point that investors may again be reluctant to invest.
"If investors have a lump sum, they could invest 20 per cent of the new money now and deploy the balance 80 per cent over the next six months," says Kumar.
Lahoti also says that waiting for a significant correction can be risky in a trending market.
"It may be better to participate in the upward trending market by shifting allocation to large caps from mid and small caps, thereby reducing some risk," he says.
Pulling out money at all-time highs: Some people pull out money when the market hits an all-time high, expecting a fall. However, re-entering the market becomes difficult due to the above-mentioned reasons.
Also, new peaks are a feature of a growing market, so exiting based on them is not advisable.
Taking excessive risks: After missing a rally or withdrawing money, some investors overcompensate by investing in high-risk segments like sector funds or small-cap funds. This should be avoided.
Instead of taking any dramatic step, investors should adopt a rule-based system of rebalancing their portfolios whenever they observe a significant deviation from the original level.
Padiyar suggests investors should avoid leverage in equity markets in the current environment. Dhawan warns against chasing momentum (investing in categories that have outperformed recently).
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Feature Presentation: Ashish Narsale/Rediff.com