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Double Your Income series: When the stock market is booming but the economy is not

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.

November 28, 2019 / 03:28 PM IST

I'll be honest with you. In my 15-year long career, I've never seen the stock market and the 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.

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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. You can follow the stock market and stay invested but then a sharp correction could erode a big chunk of your wealth.

What if you follow the economy and get out of the market?

Then, 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 percent-50 percent 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 percent within a year. Therefore, if you decide to exit at current levels, you could be giving up some mouthwatering profits.

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 up-move over the next 1-2 years.

Therefore, it will be a good idea to 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

Data Source: Equitymaster, ACE Equity

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

Historically, these returns have ranged from 14 percent CAGR over 3 years to as high as 20 percent 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 percent-70 percent exposure to stocks when the index PE is below 20x and only 25 percent-30 percent

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 a bit and move into cash.

You should perhaps try this for about 20 percent-25 percent 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.

 

(This post is a joint initiative between Moneycontrol and Equity Master. Rahul Shah is Equitymaster’s Co-head of Research. He has more than 16 years’ experience in equity research and building investing systems.)

 

Disclaimer: Equitymaster Agora Research Private Limited (Research Analyst) bearing Registration No. INH000000537 (hereinafter referred as 'Equitymaster') is an independent equity research Company. This Article is for information purposes and is not providing any professional/investment advice through it and Equitymaster disclaims warranty of any kind, whether express or implied, as to any matter/content contained in this Article, including without limitation the implied warranties of merchantability and fitness for a particular purpose. Information contained in this Article is believed to be reliable but Equitymaster does not warrant its completeness or accuracy. Equitymaster will not be responsible for any loss or liability incurred by the reader as a consequence of his taking any investment decisions based on the contents of this Article. The reader must make his own investment decisions based on his specific investment objective and financial position and using such independent advisors as he believes necessary.
Rahul Shah
first published: Nov 25, 2019 04:22 pm

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