Should Market Valuation Define Your Investments?

To understand the impact of future returns of investment made when the valuation of the market is high, our analysts studied the returns provided by UTI Index fund during different periods. The conclusion is interesting – especially if you are undecided about whether to invest through SIP or in lump sum

The Indian equity market touched an all-time high of 18,350 on October 14, up by 30 per cent from the start of the year and 56 per cent in the last one year. The market has remained one of the best performing equity markets globally year till date. The factors that are making the market move higher and higher are sequential recovery of key high-frequency indicators such as Services PMI, GST collection and Google Mobility Data, which are all trending higher on a month-on-month basis. The market trading at all time has also resulted in an increase in volatility represented by India VIX, which has increased recently.

Higher Valuation

Besides volatility, the valuation of the market also looks stretched on different valuation matrices. For example, the valuation matrix used by Warren Buffet to gauge the overall valuation of the market is total market cap (TMC) relative to the GDP of the country. This gives a good estimation of the forward returns by the equity market. Currently, the TMC to GDP ratio for India stands at 131 per cent compared to the long term average of 71 per cent. The last time we saw such higher valuation was at the end 2007 and start of 2008 following which we witnessed subdued returns for the next one year.

With monetary stimulus strengthening the economy, the market gained with upward earning momentum in FY10. This led to the TMC to GDP ratio reaching 95-98 per cent. In the current case i.e. FY22 even if we include the projected nominal GDP levels for FY22, the TMC to GDP ratio translates into 115 per cent, which still looks on the higher side. Such higher valuation always leads to lower returns in the future. This applies mostly to lump sum investment. Nonetheless, invest-ment through systematic investment plan (SIP) in mutual fund schemes may not result in lower returns. We will now explain the difference in returns when investing through SIP and lump sum at a time when the equity market valuation is high.

Valuation and Investment Returns

To understand the impact of future returns of investment made when the valuation of the market is high, we studied the returns provided by UTI Index fund during different periods. In the last 17 years since 2006 we took two different periods for study when the valuation of the equity market was much higher than the long term average. First is the great financial crisis (GFC) in 2008 and second at the start of 2018. These were the periods when we saw market valuation represented by frontline index Nifty 50 trading on the higher side. Since the start of May 2006, this index fund has generated annualised return of 11.5 per cent.

Thus, Rs1,000 invested in the fund would have become Rs5,324 by now. Now let us check the return generated by the fund if you had started investment at the start of GFC i.e. 2008. Assuming you started investing on January 30, 2008 with Rs5,000 every month, the total investment till date would have been Rs 9.3 lakhs, the value of which would have grown to Rs28.75 lakhs, thus giving a XIRR of 14.27 per cent. On the other hand, a lump sum of Rs1 lakh invested at the start of 2008 would have now been Rs3.73 lakhs, thus giving annualised return of 10.08 per cent, much lower than 14.27 per cent. 

However, the returns were better than many other asset classes in the same period. This equity market saw its low of GFC in the month of March 2009 following which it started to reach higher levels. Now assume someone had started investing in the month of March 2009 through both SIP and lump sum. There is not much difference in SIP returns as it improved by only a few basis points. The XIRR of SIP returns, if started in March 2009,would have been 14.6 per cent as of now, marginally better than 14.27 per cent. The reason for such a lower difference in SIP returns is because of longer duration of investment – the first few months of SIP installments purchased at lower NAV would not impact the longer term returns to a great extent.

Nevertheless, in the case of lump sum investment there was marked improvement in returns. The annualised return increased from 10.08 per cent to 16.08 per cent. Thus, Rs1 lakh invested in March 2009 would have grown to Rs6.5 lakhs by now. Now let’s take another period of study to understand the return pattern. After a vertical rise in the year 2017 the market saw a sharp drop and sideways movement during 2018. The immedi-ate trigger for the fall was re-introduction of the Long Term Capital Gain Tax. So if you had started investing from the start of February 2008, you would have earned return i.e. XIRR of 25.99 per cent through the SIP route.

In the case of lump sum investment you would have earned only 15.71 per cent. Therefore, with a monthly SIP of Rs5,000 working out to a total investment of Rs2.25 lakhs, the amount would now be Rs3.59 lakhs. After touching a high in January 2018, the equity market saw a fall due to India’s so-called Lehman crisis with default of India Infrastructure Leasing and Financial Services. It touched its low in October 2018. If you had started investing in October 2018 when the market saw a fall, the SIP return till now would have been 31.63 per cent while the lump sum investment would have been 22.91 per cent. 

Conclusion

There is lot of research on whether one can time the invest-ment. The study shows that timing the market is a futile exercise as no one has achieved great results on a consistent basis. There are a few lucky ones; however, they are few and far between. Investing based on valuation of the market is a way to time the market and therefore should be taken with a pinch of salt taking into consideration its historical record, which suggests it’s very difficult if not impossible to time the market. Market valuation definitely determines the perfor-mance of your investment. However, the above study shows that it makes sense only if you are a very long-term investor.

You should be able to predict the bottom of the market and remain invested. For shorter duration, the difference between return by investing through SIP and lump sum is not great and in fact SIP returns are better than lump sum investment in the shorter duration. For example, in the above case of return analysis of investment made in 2018 both at the top and bottom of the market we see that the SIP returns are far superior then lump sum investment. Hence, it’s always better to invest based on your risk appetite, investment horizon and financial goals and not on the valuation of the market.