On Tuesday morning, stock market investors woke up to a sea of red. The Sensex plunged 1000 points in a matter of minutes. The Nifty 50 was down 3%. The more opportunistic among you deployed more into markets. The more wary worried. And most wondered if this was a good time to invest and whether more fall was in store. In the year to date, the Nifty 100 index is down 1.2%, the Nifty Free Float Mid-cap 100 is down 8.2% and the Nifty Free Float Smallcap index is down 11.1%. So what drove the fall?
Global factors spark the fall
Though yesterday’s 1.6% was a sharp drop, markets had been on a downward phase for the past week. The Sensex and Nifty 50 hit a high on January 29th. On February 2nd, markets dipped 2.3% and followed it up with a 0.9% dip on Monday. The popular perception was that this was the fallout of the budget proposals. Little attention at the time was paid to what was happening in global markets.
However, the market correction is a result of global selling and not a domestic one. Across markets, 2017 and the start of 2018 was exuberant. But markets began correcting last week, with the US markets at the centre of the storm. US indices corrected around 4% last week, main European indices were down 3-4%, Asian indices were down 1-2%, and our markets were down 2.4%.
That sell-off deepened into a 1,175 point rout in the Dow Jones Industrial Average on Monday, the steepest fall since 2011. This sparked off a decline in Asian markets the following day. Japan’s Nikkei and Hong Kong’s Hang Seng both lost over 4% yesterday. Two trends led to the fall.
- Rising US Treasury yields: US yields have been rising from around September last year, on rate hikes by the US Federal Reserve and expectations of rate hikes. 10-year US treasury yields spiked to 2.75% by February from around 2.05% in September last year. Rate hike expectations beyond indicated hikes intensified last week, as US jobs data showed wage growth rising at the fastest pace since 2009 causing worry that it would lead to higher inflation and faster rate hikes.
- Rising stock markets: Across markets, 2017 was a great year. The Nasdaq, the S&P 500 and the Down Jones Industrial Average were up 20-28%, Asian markets were up a similar 20-36% through indices such as the Hang Seng, Nikkei, Kospi and the Nifty 50. Rapidly rising stock markets meant that valuations were getting expensive, though there was some earnings growth. Markets were also factoring in good growth with steady inflation.
The gap between stock and bond yields narrowed; last week’s concerns over inflation, and further and faster resultant rate hikes were the catalyst for selling in equities. Higher yields make bonds more attractive and equities lose their sheen. Rate hikes in US not only impact that market there but also institutional flows across markets. This is because the arbitrage opportunity from borrowing in US (at higher rates) and investing elsewhere narrows.
Domestic picture holds
With global selling, it is inevitable that it has an impact on our markets too. However, domestic flows provide some balance to FII flows, as has been seen over 2017. DIIs are also opportunistic, using FII selling to accumulate stocks and using FII buying to offload them. January 2018, in fact, saw FIIs buy a net Rs 9,568 crore while DIIs bought a net Rs 398 crore. In the past two days, DIIs have bought Rs 2,863 crore against an FII sale of Rs 3,589 crore.
When it comes to domestic market drivers, nothing has materially changed between the January market high and today. The budget did fulfil market expectations of a higher fiscal deficit and fiscal slippage. However, this higher spending has been mostly directed at productive spending – such as strengthening rural infrastructure and agricultural markets, healthcare and social security. To some extent, these are not simply giveaways and work towards strengthening the economy over time. The budget proposals did not have much to offer to or take away from corporate growth prospects, and for the market to react to. Our take on it is here.
Further, corporate earnings are showing improving signs of recovery. We already wrote about it a few months ago based on September 2017 quarter results. Going by the December 2017 quarter results available so far, corporate earnings growth has sustained. Aggregate profit for about 1000 companies has grown 25% for the December 2017 quarter over the year ago. Close to half the universe clocked double-digit earnings growth. Revenue growth was also in double-digits, at 14%. Earnings growth can continue to recover as, for one, the GST and demonetisation had delayed recovery and two, a lower base will help. Over the longer term, therefore, growth drivers as we detailed in our 2018 equity outlook continue to hold.
A marked feature of 2017 markets was the complete lack of volatility. Price-earnings multiples were also pushed to levels close to that of the 2007 market. We had flagged this in our 2018 market outlook. Given the lack of market fears and the stock market run up ahead of fundamentals, bouts of correction provide a welcome opportunity to get stock valuations into more reasonable zones.
Between end-December 2017 and now, the Nifty 50 PE multiple has dropped from 26.9 times to 25.4 times. Funds had a hard time in 2017; based on metrics such as valuations, growth trajectory, visibility of growth, and so on, there were fewer stock opportunities. Mid-cap and small-cap funds were hit especially hard on this front, with less than a quarter of the category managing to deliver returns better than the mid-cap and small-cap indices. The chart shows the movement of the Nifty 50 index and PEs. You can see how the correction has led to better PEs.
A market correction coupled with a recovery in earnings, and a broad-basing of growth can bring valuations in line. It will also serve to calm the fever pace of the market which saw an addition of 2,226 points to the Sensex in the span of a month. Corrections, therefore, are not to be feared especially at this point. Apart from global factors, events such as monetary policy, assembly elections and anticipation of the general elections, trajectory of inflation and interest rates could keep volatility up.
Strategy to follow
For those of you who ask us whether there will be more correction ahead, our answer is: it isn’t possible to predict how far down the market can go; markets have already moved back into positive territory on global cues. As we said before, while long-term drivers are intact, a part of market returns was front-loaded in 2017 and volatility can sustain through 2018 in reaction. A 1000-plus point single-day Sensex fall may be rare, but volatility can provide buying opportunities for investors with a long-term perspective. Here’s what to do when markets correct:
- If you have STPs running from liquid into equity funds already: Use market corrections like the one yesterday to switch an additional sum into equity from the liquid funds. This switch should be made apart from your regular STP. This can help buy more on steeper dips and effect better averaging.
- If you have a large fresh investment to make: Do not invest it at one go because markets look like they are correcting, nor should you put it off waiting for markets to correct some more. There is no predicting the market. The easiest thing to do is to start an STP and run this over the next 10-12 months and add to it as mentioned in the previous point if markets correct sharply. If you have the ability to track markets, you can also consider splitting this lump sum amount into smaller sums and wait for steep corrections to deploy it.
- If you have SIPs running: Continue to run these and do not stop SIPs because markets look to be sliding. With the lack of any significant correction in the past three years, any market decline will help bring down costs. You can add to your equity funds outside of the SIPs on steep market corrections, if you have small surpluses.
When you’re deploying the additional amounts, know that there is no necessity to add new funds each time. When markets correct, make additional investments in your existing equity funds.
- If your portfolio mid-cap allocation is already at 25% or thereabouts, refrain from stepping up investing here even if mid-caps are correcting more sharply. Mid-caps and small-caps have had a much longer and higher run than large-caps. Earnings recovery and valuations, at this time, are more attractive in larger companies than the smaller ones. Mid-caps need the steeper correction to bring them back in line. Hence, to try and average mid-caps at this point may be a slippery slope.
- Add to holdings in large-cap and diversified funds, especially if your mid-cap exposure is on the higher side. This will help reduce overall portfolio volatility and bring in diversification. You can also add to balanced funds, especially if you don’t have a debt component to your portfolio.
- While you add equities, don’t lose sight of the fact that the increasing yields have made accrual opportunities more attractive. When you are adding equities, do not ignore asset allocation with some debt funds in the income accrual space.
FundsIndia’s Research team has, to the best of its ability, taken into account various factors – both quantitative measures and qualitative assessments, in an unbiased manner, while choosing the fund(s) mentioned above. However, they carry unknown risks and uncertainties linked to broad markets, as well as analysts’ expectations about future events. They should not, therefore, be the sole basis for investment decisions. To know how to read our weekly fund reviews, please click here.
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