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Froth in valuations in small, midcap stocks; investors should adopt precaution: Expert

"We expect India’s growth cycle to be led by consumption sectors"

India Financial Markets Representational image | AP

The relentless rally in equity markets that started towards the end of March 2020 continues and the benchmark BSE Sensex closed above the 60,000 level for the first time on Friday. What next? Will we see further gains? Is time to become cautious and book profits? Which are the sectors that are likely to do well going ahead? THE WEEK caught up with Dhananjay Sinha, managing director and chief strategist at JM Financial Institutional Securities for some answers.

Q. What's the outlook on the markets over the next 3-6 months?

The market is currently swinging between strong momentum and patches of directionless sentiment. There are multiple inflection points at work simultaneously. These include the advent of slowing global growth, China’s housing sector disturbance and US and other countries embarking upon monetary policy normalisation amid a higher-than-expected inflation trajectory. The post-pandemic rally in global equities including India, which has outperformed the most, has been driven by the liquidity deluge initiated by large central banks, especially the US Federal Reserve. There is an imminent tempering on this liquidity exhilarant in the coming months and years. Hence, dynamics are definitely changing. The base case is that this normalisation is gradual and predictable, which should still be supportive for the markets. But the situation can also change if central banks get too concerned about inflation and growth in emerging markets (EMs) continues to slow

Q. Experts have for some time talked about market valuations being expensive. But we continue to see new highs and investors continue to pour in money.

There are concerns on valuations across the world and even for Indian markets as our benchmark indices are on the expensive side on a global comparison. And even at the broader market level, because of the strong retail participation enabled by huge surplus liquidity, corporate deleveraging, weak credit demand and growing deposits, the valuations for small-cap segment relative to large caps or benchmark indices are at an all-time high, higher than the bubble valuation in 2017.

Q. Should investors be cautious then? What are your concerns?

Retail investors should definitely adopt adequate precaution in stocks they are investing in as there is froth in valuations in small and small midcap stocks. We have seen the repercussion of the 2017 midcap bubble valuations and how they unfolded in 2018. Suppression of liquidity premium, optimistic earning expectations, and over-valuations are key concerning factors.

dhananjay-sinha Dhananjay Sinha, managing director and chief strategist at JM Financial Institutional Securities

Q. The Federal Reserve has talked of tapering their bond buying programme. The crisis of the Evergrande Group in China looms too. Should investors be prepared for a big correction? Is this a possibility now?

Markets have taken a benign view on both the Evergrande Group’s $300 billion debt default risk and the US Fed shifting its stance from dovish tapering to a hawkish one. The underlying sentiment is to sustain the momentum, pricing in some kind of resolution in the Chinese crisis, and that monetary policy normalisation in the US will be gradual. Thus, for the markets to undergo a significant correction of 5-10 per cent, some of these concerns will have to re-emerge, which in my view is a fair possibility. A Chinese slowdown led by housing sector implosion will have ramifications for emerging Asia growth, including for India. Likewise, the US Fed has kept its option open to speed up its normalisation if inflation remains elevated. However, it will be fair to say that India's financial market conditions will remain cushioned given the buffer of large foreign reserve with the RBI, deleveraged corporate balance sheets, and capitalised banking system.

Q. Where are the areas/sectors you see value or opportunities in even now?

In the context of expected normalisation of global and domestic liquidity in the coming months and years amid slowed post-COVID trend growth and high valuations, we believe that investment strategy should be closely aligned with the emerging business cycles and visibility of earnings and sales growth.

We expect India’s growth cycle to be led by consumption sectors on the back of improved employment arising from the normalisation of operation across multiple sectors as of now, most sectors are operating at 20-30 per cent lower operating levels compared to pre-COVID. In addition, we can expect continued support from government spending in infrastructure, defence, and development programmes.

So, our preferred space will be consumption sectors including stapes, durables, discretionary, autos and auto ancillaries and pharma. We also think that the IT sector has a structural tailwind in the form of rising order wins and income growth which might continue. Residential real estate in IT hubs can be considered as a second derivative of the booming IT sector, Within the industrial segment, we are selective, focused mostly on consumables.

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