Investors May See A Test Of Stock Allocation Skills Now

It's been one of the best runs in Indian markets in recent times. The bellwether BSE Sensex has returned nearly 18 percent in a mere three months. Spectacular, to say the least. Extrapolated into the year, this is works out to 75 percent annualized gains, which, yes, looks even more spectacular!

Large caps have turned darlings of investors in the market in no time after being battered due to carpet-bombing like selling by foreign investors. And now the rise is attributed to low valuations, hopes of an above-average monsoon, and better-than-expected earnings season, and yes prospects of a revival ahead.

Of course, the extrapolation is on paper, but a large number of domestic retail investors are increasingly getting attracted by the market's recent rise. The crucial 26000-level mark is a psychological hurdle that has been overcome and if these elevated levels sustain more retail investors will be getting in for fear of missing out on more big returns.

At this level, suffice it to say that the cream of the returns is behind.

In the run up, a number of stocks have done exceedingly well so much so that even randomly picked portfolio in the large-cap space would have seen some good returns. Not quite likely again.

Investors now may have to cut back their expectations. The best returns are always made by the early bird investors. Even if the market ought to rise to around 30,000 levels, investors entering now are likely to be making returns of around 13 percent.

At current levels, stocks are not inexpensive, and neither pricey. Before the rally, the markets were trading at 15.7 times current earnings, now they are at 19.8 times. The dividend yield of the bellwether Sensex is around 1.45 percent, which shows that investors are getting a decent yield.

But it also does not mean that returns are going to be easy in the coming months. Besides, at higher levels, the riskiness of the market increases. The margin of safety diminishes. At higher levels, investors have to be more discerning to get into the right stocks, while stock picking skills are tested.

For now, if stock markets are to see another spectacular rise, more triggers are needed. Either the RBI needs to cut rates in the upcoming policy or the US Fed has to postpone its rate hike cycle down further by about six months.

But if that is not coming, the time has come for investors to do their basic homework. At higher levels, stock valuations get pricey. Loftier stock valuations are sustained when the earnings growth is lofty enough - and sustainable enough. If there is a slight miss in the earnings beat, the markets can be quick to punish a highly-valued stock.

On the other hand, the opposite is equally true. Stock markets are quick to reward companies that spring up good earnings growth. The current earnings season has shown that the markets are getting highly discerning in rewarding the winners from the also-rans.

Hence, it's time to revisit the textbook. And the text book says always look for low valuations and better earnings growth.