Markets peaking; want to sell, answer these 5 questions

Let us first look at valuations based on PE ratios.

Oct 20, 2021 03:10 IST India Infoline News Service

In the last few weeks, there have been repeated queries on whether the markets have peaked or nearing a peak. As in the past; nobody has clear answers to the question beyond saying that investors have to be cautious. Let us first look at valuations based on PE ratios.
Data Source: BSE

The above chart represents P/E ratio of Sensex over last 14 years since the global financial crisis (GFC). If you thought that the GFC was the richest valuation ever, think again. At the peak of the 2007 rally, the average Sensex P/E ratio was 22.61. Today, the PE stands at a median of 31.48. Since 2017, the P/E ratio has been consistently above the global financial crisis peak. But, why is the wall of worry building now?

Numerous factors driving the wall of worry

Indian valuations have been rich for some time and, perhaps, became a lot richer in last few weeks. Here are some factors worrying investors.

• The Chinese Evergrande crisis threatens to spill over. In addition, Chinese GDP growth has slowed by 300 bps sequentially to 4.9%. The combination of weak GDP and Evergrande could cause a hard landing for China. That means two things. It will be a dampener for commodity demand, something India is relying heavily on. Secondly, the PBOC, may look to pull the economy out of the woods by weakening the Yuan.

• There is the issue of higher US inflation and the likelihood of the Fed front-ending taper and rate hikes. That may force the RBI to become more hawkish in its monetary stance and that could give a mini shock to the Indian markets, especially considering that the rally is liquidity driven.

• Lastly, there is a huge issue of cost inflation. India is facing steep inflation in cost of crude, freight, transport, coal and energy. All these are eating into the cost structures of Indian companies as is evident from the first few results announced by Nifty companies.

The combination of above factors is worrying investors at current price levels.

Great, but first answer these 5 questions?

If you are worried about valuations and want to exit, then the next logical step is to critically evaluate the decision. Ideally, you should start by answering these 5 questions, which will simplify your decision process.

1) Are you in the stock as a trader or as an investor?

If you are a short-term trader, you are likely to be driven by stop losses and price targets. In that case, you would not worry about the long-term prospects of the stock. If you feel that the probability of the stock hitting stop loss is higher than it hitting the price target, you would exit the stock. However, if you are a serious long-term investor in the stock, you must ask if there are fundamental concerns about the stock or sector. Otherwise, it may not add much getting in and out and the net gain may not be very meaningful for you.

2) What are you planning to do with the money after you sell?

That is an important question since money has an opportunity cost. You cannot keep it under your pillow as it is too risky and earns nothing. Most debt instruments are giving measly returns and liquidity may be a risk. You can shift to other shares but you must be sure that the switch really makes sense. After all, in the stock market, a known devil is always better than an unknown angel.

3) What are the tax and cost implications of the exit?

This is something we often ignore. Today capital gains on equities are taxable; at 10% in case of LTCG and 15% in case of STCG. If you sell a stock in less than a year because you think it is overpriced, the cost of STCG plus cess plus brokerage and statutory costs will wipe out 20-22% of your gains. Unless you are a superstar portfolio churner, these kind of costs will hardly make any sense to you.

4) Are you better off restructuring my portfolio?

One of the smart ways of trading is to buy on rumours and sell on news. It often happens that some stocks rally based on expectations and become too risky at higher levels. That is the time to restructure the portfolio, not the time to exit the markets en masse. That way, you will add to you costs and effectively gain nothing. By restructuring, you book gains on slightly “Iffy” stocks and reallocate the money into fundamentally sound stocks. It also automatically cleans up your portfolio.

5) Is the sell decision in sync with asset allocation?

This is last and most important question you must answer. If your original equity allocation was 60% and the rally takes it to 75%, there is a case to sell out. Then, it does not matter whether Sensex will go up or down. What matters is that it is not in sync with your allocation. In fact, if you follow a simple asset allocation approach, half your doubts will be automatically addressed.

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