Market Valuation: As the market valuation is reasonable, here’s how to invest

There is some beauty in asset allocation. It provides shade in times of storms but on nice sunny days, it allows the flexibility to be enjoyed a bit more. Am I too new to say that we all want better risk-reward opportunities? It is omnipresent. The question statement is then, how do we achieve that objective? For that goal, looking at macro data, valuations, yields, central bank action and more help complete the puzzle. In investing, however, even a complete puzzle looks different to different people. So, here is our interpretation of the data and the opportunities in the current market scenario.

The market narrative has rapidly changed from screams of “foamy” to “fair”. From a high of 32+ on the Forward PE Multiple, valuations now look reasonable at ~20x. Even the broader market has seen a correction, with only 20% of the NSE 500 stocks trading above their 200-day moving average. More than 50% of the shares have corrected more than 30% from their 52-week peak. Clearly, correction in prices has brought some relief to valuations. The key to successful investing is to pay less than it’s worth. So what can investors do?

Let’s try to understand what caused the volatility in valuations. Earnings had fallen during the outbreak of the pandemic and came back very rapidly thereafter. In addition, interest rates were extremely low. These factors are now reversing – bringing within the logic of last year’s somewhat meaningless valuation. It creates an entry opportunity in specific sectors which should be availed. Looking at the macros and valuations, there is opportunity in banks and other financial, auto and subsidiaries, health care and some building materials.

To begin, let’s address a global trend that is emerging. India’s domestic growth appears to be resilient while developed economies are weakening as they have taken the crutch away from the outbreak of the pandemic. Sequentially, the high frequency data for the US and EU is deteriorating while India is showing resilience. This keeps us focused on the stocks and sectors that are benefiting from domestic growth resilience.

The second trend is the flattening of the yield curve. historically, when reserve Bank of India As rates rise, long-term returns stabilize. This is either because it has already increased significantly or with rising rates, the growth outlook has deteriorated. In any case, the short term yield rises in direct relationship with the RBI’s repo rates and when the long term stabilizes, the yield curve flattens. When such a scenario occurs, it is time for lenders (banks) to extend loans to borrowers (metals) and users of goods (autos) to producers (metals). So, while metals have seen an uptrend over the past few months and have improved in the immediate term, our view is more aligned towards owning banks and autos.

There are other fundamental tailwinds in banks and autos as well. Credit growth is improving with the latest number at 11% YoY. Rising rates are also good for banking profitability. The auto business was going through a rough patch and volume numbers were well below trend. With metal prices, especially steel prices, easing in Auto’s EBITDA margins is likely to improve. A strong bottom-up outlook is likely to deliver decent returns in these sectors. Both these sectors will benefit from resilient domestic demand.

Another sector that we like is pharmaceuticals and healthcare, which is now becoming a structural theme. Both domestic and global pharmaceuticals are now trading below long-term averages. Additionally, it is a defensive area worth owning. Therefore, allocation to pharmaceuticals is warranted.

While we have talked about equity sectors, asset allocation is incomplete without balancing it with debt. On the debt front, since rate hikes are expected, it is prudent to add short duration bonds. However, as we approach a time when the long end seems to be stabilizing, it would be prudent to add duration bonds. Even without the technicalities, a moderate risk appetite may consider allocating 50% to Equity, 10% to Alternative and Hybrid and the remaining 40% to Debt.

Even after saying all this, the investment mantra remains – suit yourself! tailored to your risk appetite, goals and individual circumstances. And while you’re at it, remember that nothing in life and investing in it lasts forever! Therefore, we need to create resilient mechanisms to deal with good and bad.

(Author, Ankita PathakHere are the Product Managers and Macroeconomists DSP Mutual Fund, thoughts are his own)