A plain-vanilla interpretation of this could be to start cutting exposure to the red-hot stock market. But, in a market driven by ifs and buts, a cut-and-dried approach may not work, throwing up the need for a more nuanced approach.
The current reality is that the momentum on Dalal Street is strongly in favour of the bulls. The extent and timeframe of market declines in recent times have been short and shallow. It has been a case of one step back and two steps forward in the market, prompting some analysts to recommend that clients invest lump sum amounts in Nifty index funds and ETFs, at least till the national elections.
The current bullish wave notwithstanding, the reality is also that India’s share valuations are rich and unsustainable in various pockets. That is clearly playing on the minds of the seasoned market participants. Prominent fund managers handling the money of the affluent are telling their teams to avoid looking at fresh stock ideas at this point and are largely retaining the portfolios of 2023. Parsing large deals data shows that several institutions, including big-ticket private equity and foreign funds, have been consistently trimming their holdings in various mid-cap and small-cap stocks – considered the most expensively valued – in the past few months.
History has shown that overvalued markets or share categories tend to fall under their own weight. In a piece earlier this year, one of India’s most successful fund managers Prashant Jain cited Vanguard founder John C Bogle: “Reversion to the mean is the iron rule of the financial markets.” The challenge here is that it’s not possible to time exits based on valuations.
So, when froth is evident in the market, how does a ‘One Foot Out of the Door’ plan work? According to experienced market participants, there is no foolproof strategy here. The key idea however is to cut risk.
Some informed investors buy put options as insurance against erosion in their long-term portfolios. Analysts said the recent rise in the implied volatility – a crucial aspect of options premium pricing – of Nifty put options suggests the purchase of such hedges.But retail traders might find it tedious to time such purchases and exits of options. They may be better off following a strategy implemented by investors who have seen multiple market cycles. These market participants tend to smooth the rough edges in their equity portfolios by identifying excesses in stocks early and trimming exposure even if that means missing out on the most exciting phases of a bull market.
According to a senior mutual fund manager, currently, small-cap and mid-cap stocks, especially in PSUs, energy, construction and capital goods, are most vulnerable to downside, purely on the basis of valuations, though they will remain the favourites of momentum traders.
Cutting allocation to richly valued stocks does not mean holding cash and staying entirely out of the market. The idea is to reduce allocations to crowded spaces in the market. High net worth investors are steadily deploying money in select debt mutual fund categories such as corporate bonds, banking and PSU funds and medium-term gilt funds that are seen benefitting from a likely cut in interest rates later this year or the next. Some of the more value-oriented are shifting part of the money to funds focused on the beaten-down stocks in China and Hong Kong, which have been on a losing run in the past three years.
In short, one of the overarching strategies for investors in 2024 must be to safeguard the gains made in the past two years.