General optimism with a hint of its excess buoyed markets up in mostly all parts of the globe. While at the face of it, it might seem that an equity investor could not have missed making money in 2017, but for me, it has been anything but easy. The optimism seen in equity markets, especially in Indian equity markets, roiled me with conflicting emotions throughout the year. The price movements seen in most stocks that were held in the portfolio were anything but par for the course. For example, Maruti Suzuki, my favored auto stock in the portfolio, moved up about 30% in a span of four months, mostly based on multiple expansion. Somehow when a dynamic like such plays out in most stocks in a long-term oriented portfolio, buy and hold becomes a difficult proposition as stocks reach their assessed fair value or even become overvalued at an extremely rapid rate. I clearly don't think that Maruti Suzuki should be valued at 40x TTM with its close to 15% annual sales growth, even when its margin expansion is taken into the equation. Extrapolating current trends insanely into the future is a routine mistake that equity participants in markets are prone to make, especially when majority of equity market performance is a factor of optimism rather than fundamental earnings growth.
Almost everyone in India is talking about the impending earnings growth that is likely to come in the near future. Likewise in the United States, equity market optimism is based on healthy earnings growth seen, although from what I assess, it is not spectacular by any means at ~20% if we take into account the buyback factor that has been in place for some years now. With oil no longer in its 20s or 30s and yield curves in the US nearly flat (0.5% odd differential), and the Fed and other central banks on an upward cycle on base rates, it is but hard to see how equity markets can keep going up as it has till now. By the looks of it, if the trend does continue, we would be in a completely new territory that we have probably never witnessed in the past. History will be rewritten and cycles will break.
Till some months ago, as I had alluded to in my past monthly updates, I have been cautious in the later half of 2017 yet did not take action on it for the most part. The portfolio now has cash at above 60% with mostly opportunistic event driven names as holdings. None of them (RCom, JP Infratech, and Bhushan Steel) are compounding machines but are restructuring/ reorganization, cigar butt bets. My analysis concludes that the risk of derating owing to factors I have not yet foreseen in well-managed compounding businesses is much above the risk of almost binary outcomes in the event driven names. Added to that, the allocation to event driven names is at a significantly reduced level to control overall portfolio risk. I believe that the risk-reward equation is much better in my portfolio now than it was days back when the portfolio was fully invested in good overpriced compounding stories.
Lately, equity market experts have tried hard to discredit that notion that equity markets may be expensive. They mostly cite the relatively lower multiples we have witnessed than in 2008. Somehow, I see those arguments akin to saying that previously, a 100-ton trailer went over a 90-ton capacity bridge without harm, so a 95-ton trailer passing through would be safe. On a relative plane of reasoning, this argument might make complete sense but is crazy on an absolute reasoning plane. Even more absurd is to judge the relative creditness of the system that existed in 2008 and now and somehow come to the conclusion that the markets are safer than in 2008.
It may not be completely sane to think that valuations, creditness etc. will have to reach previous levels before we see a revaluation of equities. Explanations to why something should go up or down can range from 'new normal' or 'my chicken has laid five eggs rather than four' but ultimately if we try and assess from first principles as to whether we are on overvalued territory or not, the best place to start is to understand the current level of perception of risk.
The rise in this phenomenon called bitcoin, markets not even pausing to take a breather when there is a rise in fed rate, not discounting for the fact, up or down, that oil price is going up again all point to an environment where market participants, in general, have somehow gotten past the era in their memory lane when markets could be decimating. That in my view, is the real risk because it is then when equity markets may start showing up its bloody head again.
Timing the market is impossible and I am not trying to, but to be cautious when people show greed may be a useful mentality to have.