Stock market rally: 6 points to consider before you take the plunge

Karan Deo Sharma
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Stock market rally: 6 points to consider before you take the plunge

Stock market rally: 6 points to consider before you take the plunge

Indian and global stocks markets are on a tear. The benchmark Nifty 50 index is up nearly 10 percent during November itself and 70 percent since its March low. These gains came despite 200 points correction in Nifty 50 on Wednesday – one of the sharpest in nearly one-and-a-half months. This may inspire many investors to jump in the market at the current levels given the positive sentiment all around amidst a constant flow of positive news regarding COVID-19 vaccine and election of Joe Biden -- the pro-trade and pro-growth President of the world’s largest economy USA. The temptation is especially strong for investors who either missed the recovery trade from March till now or didn’t participate in the rally in 2017 or 2019.

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But here are a few points to consider before you decide to jump into the market right now especially after this Wednesday’s correction.

1.       The market remains expensive despite the recent correction. The benchmark Nifty 50 index is currently trading at a record valuation of little over 35 times the combined net profits of the constituent stocks as captured by its earnings per share (EPS). This is nearly 20 percent higher than the index peak valuation in the pre-COVID period. Earlier, the index used to trade at around 28-30x its EPS at the peak. Investing at the peak of the market valuation raises the downside risks for investors and makes it tough to make money, or at best, it significantly increases the pay-back period.

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2.       Timing is the key for making money in equity markets. For example, investors who entered Nifty at its 2018 peak in August that year have got annualised returns of just 4.5 percent during the period. Nifty price to earnings multiple has reached 28.5x in August 2018 – the highest in nearly two decades. In comparison, those who waited for some weeks and entered the market in October 2018 when there was a correction earned an annualised return of 13 percent, which was better than most other asset classes during the period. Index P/E ratio had moderated to 25x in October and that made all the difference in the returns profile for investors.

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3.       Fundamentals are still to catch-up with stock prices. Despite all the positive commentary on corporate results for the second quarter (July-September 2020) period, corporate earnings are still down nearly 20 percent from their high at the end of December 2019 quarter. However, the combined market capitalisation of all listed companies is around Rs 10 lakh crore higher than the pre-COVID peak value. Obviously, investors expect a faster than expected restoration in corporate profits and income in India from the COVID-19 shocks.  But recovery is likely to be a long drawn process.

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4.       Assuming complete economic and business normalcy it will take companies at least two years to grow their earnings to pre-COVID levels. Similarly, India’s Gross Domestic Product and per capita income will reach its 2019 levels before the end of 2022 assuming a linear recovery from here on according to projections by the International Monetary Fund (IMF). However, many economic variables can take a turn for the worse over the next two years that could delay recovery by many quarters if not years. As an equity investor you need to hedge against those risks and thus tone down your expectation and risk premium (our valuation) that you are willing to pay for buying future growth.     

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5.       Stay away from the stocks and sectors that could be driving the rally at that moment. Every rally has its leaders and laggards and retail investors are not advised to chase leaders. You never know when the market momentum will shift and leaders may turn into laggards. For example, retail lenders such as private sector banks and non-banking finance companies were rally leaders by a big margin in 2018 and 2019 but most of them turn into big laggards this year forcing many investors to book losses. Similarly, BSE Auto Index that tripled in value between 2011 and 2017 is still down 25 percent from its highs despite three-years of recovery and a rally in the broader market during the period.

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6.       Mid and small caps have underperformed the broader market in the last three years. The benchmark indices BSE Sensex and Nifty 50 made fresh life-time high in October this year but Mid and Small Cap indices are still to reclaim their previous highs. For example, BSE Mid-Cap index is still 10 per cent lower than its record high made in January 2018 while BSE Small Cap Index is still down around 20 per cent from high. This opens-up an opportunity for investors to buy quality mid and small cap companies at attractive valuations. Historically, rallies in mid and small stocks always follow a rally in large-cap stocks that are part of the benchmark indices. Given this, the risk-reward ratio favours investment in quality mid and small caps rather than large caps that seem to have run their course for now.

Happy investing!

(Karan Deo Sharma is a Mumbai-based finance and equity markets specialist).

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