Why you must beware of the bull trap in an overvalued market

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“Be fearful when others are greedy and greedy when others are fearful” - Warren Buffet

The relevance of this famous quote has been there for everyone to see this year. Buyers across the world during the March lows are now reaping benefits of their bold investments. However, the surge in global markets to all-time highs has put one question in everyone’s mind—“Is it time to be fearful?”

In my opinion, the markets, especially the benchmarks do carry a sense of overvaluation. As of December 17, the NIFTY50 was trading at a premium of 37.79 which is an all-time high. While the index as a whole may be overvalued, what we need to look for is to what degree is each company in the index/market overvalued.

There are multiple factors that have led us here. A market that is flush with liquidity due to low interest rates not only in India but low interest rates in developed economies like the US have also brought higher quantum of money to the Indian markets.

High inflation driven by supply constraints in the consumer segment has also forced consumers to look at higher risk investments in the hopes of beating the high inflation rate.

It is not easy to pinpoint when the markets will turn bearish. In the short-term, adverse news around Covid-19 and lockdowns may influence sentiment negatively causing markets to correct to a certain extent. To prevent capital erosion, one must tread carefully with adequate hedges in place to cover for the uncertainty.

For long-term investors, in terms of portfolio construction, this time calls for more of a top-down approach than a bottom-up analysis. Expensive valuations shouldn’t deter investors from spotting opportunities. In this economic environment, the macroeconomic impact is much more relevant to shake the sentiment than at normal VIX (Volatility Index) and PE (Price-to-Earnings) levels.

For example, if the delivery of the Covid-19 vaccines is supported by good logistics and deliveries are efficient, the imminent positive impact can be mapped on aviation-related enterprises due to pent up demand, festivities, and commercial travel among other factors. If successful, the secondary market impact include airport traffic, cab bookings in the metropolitan cities and improved seating capacity in an aircraft.

Another thing that should be monitored is the law of averages. Nifty has been rallying unidirectionally since the beginning of November, without proper pullbacks. That is not a healthy display of a trend, even if the ground level valuations were justified. This implies that the market needs to find the new mean and a reversion upon discovery is pending. It might not be a reversal in the sentiment or trend but at least it is safe to say that a correction or pullback is in order in the near term considering the law of averages.

New investors, who spawned during the bull market, are prone to make purchases in lieu of peer demand. We all know that anyone who has made an investment post-March, and held on for even a quarter, made decent returns. When most people, especially a cohort of retailers make decent returns in the short term, they end up attracting a mass to indulge in similar activities with similar expectations. Unfortunately, this mass may not be equipped with a similar risk appetite as the more experienced investors.

There are a few ways to provide safety to a standard portfolio, among which one that will also suit a vanilla investor, is asset diversification. By introducing a debt component, both short-term and long-term, one can secure a natural hedge against any economic instability. This can also protect investors if their sectoral exposure is higher on financial services in certain situations.

On the other hand, by introducing a precious commodity component such as gold or silver, a portfolio can secure another natural hedge towards more qualitative uncertainties such as those that are political and cultural in nature. The good news today, is that one may not have to purchase physical commodities anymore. Today gold can be purchased in the form of ETFs which are transparent and easy to track.

Finally, what is important to understand is that absolute greed has a place neither in the rising markets nor in the falling ones. Every investor, just like their investments, has to go through certain learning curves and cycles. Seeking shortcuts and having unrealistic expectations on returns might fetch results in the short term, but it will be just as unhealthy as a rally without periodic corrections or high PE stock with dwindling on ground valuation relative to the peers.

The writer is co-founder and CIO of investment firm True Beacon and online stock trading platform Zerodha

The thoughts and opinions shared here are of the author.