»5 Minute Wrap Up by Equitymaster

On This Day - 4 NOVEMBER 2019
What to Buy at Sensex 40,000

Ankit Shah, Research analyst

For the last three consecutive sessions, the Sensex has held above the 40,000 mark. I'm sure you have many questions on your mind right now...

Now that the Sensex has reclaimed the 40,000-mark, are the bulls back in the markets for good? Is it a good time to buy more stocks? Should you invest in safe stocks or make some contrarian bets in the smallcap space?

Before I get to the answer, let's revisit the topsy-turvy ride of the markets over the last 15 months. In fact, looking back at what happened is quite instructive of how to move forward.

Here's a chart of the Sensex since August 2018.

It was at the end of August 2018 that the Sensex came within touching distance of the 40,000 mark for the first time ever - closing at a high of 38,897 on 28 August 2018.

Then the IL&FS fiasco came to the fore. The NBFC crisis, which was initially a liquidity crisis, transformed into a solvency crisis.

You can see the Sensex reacting to this development and hitting a low of 33,349 by 26 October 2019.

But you can see that the Sensex steadily clawed its way back and finally claimed the 40,000 mark in June 2019 after the Modi government returned to power with a thumping majority.

However, it couldn't retain this new high for too long. The Budget disappointed foreign investors and led to a flight of capital out of the Indian markets.

The economic slowdown worries kept growing, causing investors to get more and more pessimistic. By 19 September 2019, the Sensex corrected all the way down to 36,093.

But then, Finance Minister Nirmala Sitharaman emerged with the magic wand and announced historic cuts in corporate tax rates, causing a massive surge in stock prices.

Then since the last week of October, the Sensex has again been on a rising spree and has managed to close above the 40,000 mark for three consecutive sessions. This time, the markets have risen on the back of positive global stock market sentiments and the recent US Federal Reserve rate cut.

Let's See How Smallcaps Performed...

Here's a chart of the BSE Smallcap index for the same period...

You can see that the Sensex and the Smallcap index have had very divergent movements.

Smallcaps have mostly faced sharp corrections, while a select Sensex stocks have been lifting the Sensex to new highs.

What were the triggers that led to this wide divergence?

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In the 2017 bull run, small and midcap stock prices had run way ahead of fundamentals and were trading at frothy valuations. So, some correction was inevitable.

What made matters worse for smallcaps was also the weakening economic environment. You see, small companies are more vulnerable to adverse changes in the macro economy as many of them do not enjoy the resilience and bargaining power like their larger counterparts (but there are some companies that do, and I'm always on the lookout for them).

But what really blew the wind out of the smallcap bubble was the categorization and rationalization of mutual funds by the Securities and Exchange Board of India (SEBI).

Earlier, the definition of the stock universe for a specific scheme was at the discretion of the fund house. But that changed. The market regulator decided to define the stock universe to bring in transparency, simplicity, and standardisation.

Since the implementation of the new guidelines, any largecap fund has to pick stocks from the universe outlined by the capital market regulator. If any stocks drop out of that category, then the fund has to rebalance its portfolio accordingly.

In the bull rally of 2017, a lot of mutual funds significantly increased their exposure to smallcap and midcap stocks, which were the darlings of the stock market then.

But following the new SEBI guidelines, fund houses had to rebalance their portfolios. This was one of the triggers for the sell-off in small and mid-cap stocks.

But what happened once the rebalancing was over? Why did money not flow back into small-caps despite the steep correction?

Virtuous and Vicious Cycles

The answer lies in understanding the nature of market cycles and its deep-rooted connection with human nature.

In our evolutionary process, the human mind has been programmed to place a huge premium on safety and certainty.

Since early 2018, when the broader markets entered the correction zone, we have largely witnessed an atmosphere of fear in the stock markets.

During such times, most investors are inclined to seek safety. This is why we have seen so much money pour into high-quality, safe bluechips. This trend has worked so dominantly since last year that it has pushed the valuations of such stocks to very lofty levels. And as long as money keeps pouring into these stocks, they will continue to command high premiums.

On the other hand, smallcaps have witnessed exactly the opposite trend. Fear and panic has resulted in more and more investor apathy. Moreover, the SEBI guidelines have cut down the institutional money inflow into smallcaps.

What to Do?

So, as you can see, more and more money has been pouring into safe stocks. Smallcaps have mostly remained under pressure, witnessing only occasional bouts of enthusiasm.

In such a scenario, what should one do - follow the trend and play it safe or make contrarian bets for big long-term gains?

I think investors should not indulge in this kind of binary thinking.

In my journey through the stock markets, I have come to believe that instead of rigidly following just one investing strategy, it works to make the best of every money-making opportunity out there.

At my premium newsletter Insider, I keep a close watch on all the investing strategies that my research team follows. And then, I cherry-pick the best stocks from a gamut of investing ideas... stocks that I believe could offer great returns for my Insider tribe.

Chart of the Day

How expensive is the Sensex at around 40,000 levels? What has the trend been in recent years?

I thought it would be interesting to see how the valuation of the index has moved over the last five years.

The chart of the day maps the price to earnings ratio of the Sensex from October 2014 to now.

How Pricey Is the Sensex Now?

It is worth noting that the Sensex has gained 44% over the last five years, compounding at an annual rate of 7.6% (excluding dividends). Not quite impressive.

During the same period, the Sensex price to earnings ratio has mostly been in a rising trend, except some intermittent declines.

Between October 2014 and now, the gain in the Sensex price to earnings ratio is 42%. That means that the gains in the index have mostly come from expansion in the valuation multiple, and just meagerly from increases in earnings.

So, before taking the current market bullishness for granted, do weigh in the fact that the Sensex is quite expensively priced.

Warm regards,

Ankit Shah
Ankit Shah
Editor and Research Analyst, Equitymaster Insider

PS: My colleague Richa Agarwal, our small cap guru, has identified the 1 stock to bet on for 2020. Get the details here.

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