“History does not repeat itself but it often rhymes.”

Over the last few months, during the biggest democratic exercise of the world, all kind of people have discussed and analysed the impact of the elections in the world they live in. People in the world of finance were not the exception, There have been discussions about how market have reacted after every election and what should one do to make the most of their investments from this e.g. Article in Economic times. In my opinion, these external factors does matter and impact the earnings growth due to the change in economic policies but we have to stick to the basics and look at the market from valuation point of view most of the times.

In Nov 2018 article on Dynamic Asset Allocation, I tried to explain that with some change in portfolio of equity and debt we can beat the nifty returns just by managing the asset allocation. There is always a delay in reaction of market and its valuations, so i created the valuation index based on the Price to Earnings & Price to Book factors and looked through the 1 yr forward return for the combination. I used the data from 01 Jan 2000 to 26 May 2019, There were close to 4,576 points of observation for rolling returns. Below is the chart that represent the outcome of analysis.

Dynamic Allocation Part 2.png

Value index (25% of PE + 75% of PB) ranged from 4.23 to 11.98 during these observations so I bucketed them into 6 buckets starting from “<6” to “10+” on x-axis. In each of these valuation zones i looked at their return characteristics max returns/ min returns/ mean returns/ how many times we saw -ve returns. Below are the readings form the above chart:

  1. As the Market Value Index grows higher, the chances of market returns being -ve increases. e.g. when value index was <6 then 13% of the observations have -ve returns on a 1 yr forward basis and it increases to 49%, when value index moves to 9-10 zone. In 10+ zone, we have limited observation but 100% empirical chance that returns will be -ve on a 1 yr forward basis.
  2. The average returns in these valuation zones also changes as the market valuation increases. we saw 43% as avg 1 yr forward return when valuation index was <6 and -41% when valuation Index goes >10.

As of May 26, 2019 the value index will read as 10.2, So what should an average investor  do? This is the common query after seeing such analysis hence below are my recommendations:

  1. Use time to your advantage, If you are investing for Long haul and have >10 years without bothering to withdraw your money then continue to invest at regular intervals without any major changes (Also read Time Diversification). If you are looking to take your investments out in next 3-5 years, probably best to book some profits at higher valuation zone and move to safer options like fixed deposits/ others.
  2. Stick to your strategic asset allocation but make sure it has a component of market valuation to anchor you in right direction. If you have fixed asset allocation then make sure, you do not put new money in equity when value index is >9 and for 10+ zones start booking some profits, Similarly in case you find markets in <6 zone then try to invest money more than suggested as per your asset allocation. (Also read How much equity should you hold)

If you are an active investor and want to track markets to invest in lump sum, stay on the side for sometime before the markets correct and come below value index of 9.5 at least. Keep you money in Sweep-in or Liquid/ Arbitrage fund as per your liking. In any case stay invested and do not stop your investments just change the asset class. Happy Investing!!