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What to Do When the Stock Market is Booming but the Economy is Not?

Nov 21, 2019

Rahul Shah, Editor, Profit Hunter

I'll be honest with you. In my 15-year long career, I've never seen the stock market and the Indian economy take such divergent paths.

The stock markets are behaving as if they have nothing to do with the underlying economy. They are dancing to their own sweet music.

And mind you, this isn't a recent phenomenon.

Since 2014, the stock market has more than doubled. Most of this doubling has happened in a not so friendly macro-economic environment.

In fact, as far as the latter is concerned, things have gone from bad to worse. Barring a miracle or two, this fiscal year, the Indian economy may grow at one of its lowest rates in recent times.

However, none of this seems to matter for the benchmark indices. Despite scaling mount 40,000, the Sensex doesn't look tired at all from the effort. It is as if it can continue to go on and on and won't mind a few more milestones.

This divergence is making things very difficult for the retail investor. If you follow the stock market and stay invested, a sharp correction could erode a big chunk of your wealth.

What if you follow the economy and get out of the market? You could miss out on some real, fat gains should the stock market rally continue.

Do note it is not uncommon to see the entire benchmark index tank by 40%-50% in a matter of few months. So, imagine the kind of wealth destruction in store for someone who decides to stay put in the market.

It is also not uncommon to see the index go up 100% within a year. Therefore, if you decide to exit at current levels, you could be giving up some mouthwatering profits.

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Luckily, there's a way out of this puzzle. I have found an investing rule which is extremely useful.

Take a bet based on the valuations of the broader market and don't worry too much about what the stock market or the economy is going to do.

You see, the stock markets will keep moving between greed and fear and the economy will also continue to have its ups and downs.

However, trying to time your investments based on these indicators is an exercise in futility. There is no known method to nail it to perfection every single time. It is too complex a beast to be tamed on a consistent basis.

But there is something which is in your control. In fact, you can have a fair degree of success with it.

I'm talking about investing based on valuations of the broader market.

So, if the current valuations of the broader market i.e. the benchmark indices, are high based on past data going back many years, there is a high probability the market will have a sharp correction in the next 1-2 years.

Therefore, it will be a good idea to reduce your exposure to stocks.

And if the current valuations are low, based on past data, there is a high probability the markets will have a sharp upmove over the next 1-2 years.

Therefore, it will be a good idea increase your exposure to stocks.

The chart below proves my point.

The Upside of Investing at Low PEs and the Downside of Investing at High PEs

The Upside of Investing at Low PEs and the Downside of Investing at High PEs

A great way to boost your returns is to take a big exposure to stocks when the Sensex price earnings (P/E) ratio is below 20x its trailing twelve-month earnings.

Historically, these returns have ranged from 14% CAGR over 3 years to as high as 20% at a PE of 16x or lower.

And a great way to avoid poor returns or even losses, is to reduce your exposure substantially when the Sensex PE has crossed the 25x mark.

So, here's the broad thumb rule.

Take 60%-70% exposure to stocks when the index PE is below 20x and only 25%-30% exposure when the PE is above 25x.

And where do the valuations stand right now?

Well, the Sensex is trading at a PE multiple of 28x. It is at the higher end of the band where the probability of making good money from a 3-year perspective is not very high in my view.

Therefore, it may not be a bad idea to reduce exposure to stocks and move into cash.

You should perhaps try this for about 20%-25% of your investment portfolio if not the entire corpus. I am sure you won't be disappointed if you take this decision.

You would have noticed how the narrative shifted from what the stock market will do or what the economy will do in the near future to what an investor should do.

And I think this is exactly how it should be. There are no certainties in the stock market.

Therefore, as long as you take advantage of the probabilities and shift your allocation based on the broader valuation, you have a good shot at market-beating long-term returns.

I am not saying this is the only successful and the most effective method out there. There could be others as well.

But this is certainly among the easiest to implement without a lot of ambiguity.

Warm regards,

Rahul Shah
Rahul Shah
Editor, Profit Hunter
Equitymaster Agora Research Private Limited (Research Analyst)

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3 Responses to "What to Do When the Stock Market is Booming but the Economy is Not?"

paresh Shah

Nov 24, 2019

Two questions here;

a. Taking on your suggestion to reduce exposure in the market what should we do with the redeemed funds - the debt market is quite risky too. One option I was condidering was to sell my mutual fund holdings and then starting a sip to put it back slowly - would reduce exposure to big losses.

b. Is there any options or futures product we can consider to reduce/ hedge the risk of the fall and what would be its cost for say a Rs. 25 L portfolio ?

Sincerely


Paresh Shah

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Subhash Parab

Nov 21, 2019

If I remember you had suggested the same in one of your services in 2018 when the valuations of most of mid and small cap scripts were high.

I would like to know how it is to be done i.e. whether one has to liquidate certain scripts or part amount of most of the scripts.

I would appreciate your early comments/reply to this post.

Thank you.

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RP

Nov 21, 2019

Good, how about elaborating further as to where should the balance percentage i.e. non stock amount be invested in? What about the stock allocation if to be reduced to 25-30% what kind of stocks & where should it be invested? In which stocks should maxium profit booking be done? What about Mutual funds - can they be used for either fo the allocation? What are your views and what does history say?

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