The Nifty Is Soaring. What Should Equity Mutual Fund Investors Do Now?

India’s bellwether stock market index, the 50-share Nifty, touched its all-time high late last month; crossing the psychologically important 9,300 mark for the first time amidst much fanfare. As I write this, the index has soared past 9,350. The bulls are firmly in charge.

Unfortunately, this is usually the time when equities and equity mutual funds catch the fancy of most retail investors. Risk aversion soars in the face of somewhat unwarranted optimism, and the cycle of “reverse asset allocation” (increasing one’s exposure to equities progressively as markets become more expensive) begins. If you’re already an equity mutual fund investor, or are considering being one, what should you do at this stage?

To answer that, we need to grapple with another, more baffling question; that is, in what stage of its cycle is the flighty stock market currently positioned? Oh, if only anybody had a perfect answer to that one!

Where is the stock market headed?
To be truthful, nobody, however expert, can really predict market tops and bottoms with a significant degree of precision. At best, one can only make calculated bets based on certain key signals related to the economy and the markets. From a macro standpoint, India certainly seems nicely poised now. Inflation is being reined in, and fiscal as well as current account deficits are moderating. The impact of recent policy measures is likely to kick in over the medium term, resulting in visibly improved earnings growth.

At the same time, numerous factors are pointing to the fact that the stock markets are at a “mid-cycle” phase. For instance, collecting equity MF monies from investors is getting easier, and the IPO market is improving. CapEx and credit offtake are both starting to pick up pace.

Valuations already stretched
Valuation-wise, the markets remain stretched and 23.65 times earnings. This is much higher than the historical average and is indicative of the currently optimistic mood; clearly, markets are factoring in robust earnings growth, and therefore a higher denominator over the coming quarters. From a contrarian’s point of view, this isn’t reason to worry (yet) as irrational exuberance usually tends to accompany actual earnings growth. What this essentially implies is that when earnings growth does come, and PE ratios get rationalised, we’ll likely see much drumbeating in favor of a PE re-rating - and many perfectly rational-sounding cases justifying NIFTY levels of 15K, 17Kand even 20K will come forth! That’s when the froth will start building up.

On the other hand, if markets fail to deliver on the earnings front (also a possibility), we’ll quickly see a dissipation of the current buoyancy, resulting in a sharp and painful correction.

A concrete plan of action for mutual fund investors
Which brings us back to the question – what should equity MF investors do now? Considering our assumption that we’re in the “middle of the road” phase of a bull market, a measured dose of caution would be warranted. Investors need to re-visit their asset allocations at this stage, and aim to reduce their equity MF allocations by 30-50 per cent, in a staggered manner, over the next 18-24 months, via STP’s (Systematic Transfer Plans).

Say, for instance, you’ve got a portfolio of 10 lakhs, of which 8 lakh is into equity MF’s. Your target equity exposure at the end of an 18-24-month period from today should be closer to 3.5 or 4 lakh. To effect this change dispassionately, you should ideally start a two-year STP of Rs. 15,000 per month from equity funds to debt funds. By doing this, you’ll be resisting the temptation to time your exits, and safeguarding yourself from the dangerous reverse tendency to increase your equity MF allocation as markets move up.

If your equity investments are predominantly into the more tempestuous small and mid-cap funds, you could consider accelerating your STP duration and completing the switch to debt funds within 12 months instead of 18 or 24 months.
If you’re new to MF’s and looking to start investing now, aim for a balanced asset allocation between equity and debt funds. Even if you’re an aggressive investor, have no more than 70 per cent of your portfolio in equity MF’s. Start STP’s from your equity funds to debt funds immediately, aiming for a final equity allocation not exceeding 30-35 per cent of your portfolio at the end of a two-year period.

End note
Mid cycles of equity markets are an opportune time to begin de-risking your portfolio. You don’t need to do it immediately or as a knee-jerk reaction to news or sharp market movements. It’s impossible to really predict exactly when the party will end, but mid-cycles invariably give way to boom phases and subsequently, bust phases. By the time the next capitulation comes about, you’d want your portfolio to be concentrated into fixed income mutual funds, with only a marginal exposure to equity MF’s. Plan ahead, and start your STP’s today.