Nov 23, 2022
Where do we head when the printers stop
The month gone by was a rebound time for markets across the globe. All major global indices rallied from the bottom, while the Indian headline indices continued their outperformance and inched closer to their previous highs. A few sectoral indices like Banks, Autos, and FMCG hit new highs driven by strengths in the underlying industries.
The result season also concluded recently, and the earnings were a tad below expectations. After eight quarters of earnings growth, the Nifty earnings saw a marginal decline of 2% YoY against an expectation of a flat quarter. The input cost pressure continued to dent the margins of major businesses during the quarter. Financials continued to outperform, led by higher growth and lower credit costs.
The Sanctum Indian Titans companies outperformed the benchmark on the earnings front and delivered an ~8% YoY growth in net profit vs a decline of 5% in Nifty 200 and 2% in Nifty (details in the table below).
Source: Sanctum Wealth Research
When the Fed is on the job and raising rates in panic, we must peek into investor psychology to set the right expectations from the market.
History suggests that investors don’t sell and hide in their bunkers when there is a sustained, ferocious increase in rates. Instead, they become choosy and deploy their money wisely. That happens because 1) less money is available as the money is no longer cheap 2) investors would have burnt hands in the earlier excesses and 3) higher rates open safer, high-yielding investments for them.
As a result, the market liquidity tends to go down in such time, and the liquidity in extremely risky market segments like small-caps, new-age tech, or crypto evaporates even more.
Liquidity is essential to determine the short-to-medium-term direction of the market. The long-term though is always dominated by fundamentals. When investors get risk-averse due to less liquidity, they tend to hide in safer pockets of the market. The safer pockets therefore outperform, and risky pockets tend to underperform.
For example, when the Fed gradually doubled rates from 3% to 6% in 1994-1995, the riskier index NASDAQ delivered a 2% return while the industrials and consumer-heavy Dow Jones Industrial Average (DJI) delivered a 9% return. In another major rate hike cycle of 2004-2006, the fed increased rates from 1% to 5.25%. During this time, the NASDAQ delivered a 4% return, while the DJI delivered a 10% return.
All returns from monthly close corresponding with the start and end of respective rate cycles
Source: Sanctum Wealth Research
The current rebound in the US is also more prominent in the DJI, which is up 17% from the bottom and down 7% since the start of the rate hike cycle vs the NASDAQ which is up 10% from the bottom and down 27% since the start of the rate hike cycle. If history repeats itself, the returns on the tech-heavy NASDAQ will lag the old economy DJI until the Fed reverses its course.
In the Indian context, money never became as cheap as it was in the developed markets. Therefore, the liquidity from the banking system never found its way to speculative assets. Whenever there was a risk-off sentiment because of economic or liquidity issues in India, the small caps bore the biggest brunt and underperformed the headline and midcap indices. They also ended up outperforming as soon as the troubles were sorted.
For example, in the 2017-2018 bull run, institutional investors ploughed in over 95,000 croresin Indian equities. Simultaneously, the small-cap index delivered a 68% return, while the large- cap heavy Nifty delivered a 41% return. In the ensuing period, there were too many local and global headwinds for the Indian markets. The Fed was raising rates, FIIs were pulling out, the domestic economic growth was slowing, and an NBFC crisis was unfolding. To top it all up, SEBI came up with a new market cap categorization and enforced strict compliance on fund houses to invest based on the nature of the respective schemes. The small cap index took all this on its chin and heavily underperformed the headline indices (-37% vs 11%). Midcaps did relatively better but still delivered a negative 15% return. Most of the domestic flow, which amounted to more than Rs. 1.27 lakh crore, found its way to large-cap stocks that acted as a haven in the turbulent time.
Though India seems to be better placed in terms of macros and a lot seems to be going for the country, the current rebound from lows indicates a clear preference for large-cap stocks, with Nifty and Sensex nearing their highs while small caps still struggling. Until the global woes subside and the animal spirits come back in full force, the preference for safe large-cap stocks shall sustain.
The relative peak-to-peak underperformance of large caps in the previous run (50% vs 88%) also points us in the same direction. The underperformance of one cycle in large caps is mostlyfollowed by outperformance in the next, especially when the environment is becoming risk- off. Below is the table detailing the same.
All returns are cyclical peak-to-peak returns
Source: Sanctum Wealth Research
How are we weathering the storm?
The month gone by largely confirmed the risk-off churn prevalent in the market. The mid-caps and small-caps underperformed large caps, and even the composition of the large-cap rally was quite different from the previous run. Themes like Banks and PSUs performed well in the month, and it remains to be seen if this is a sustainable move.
In our flagship portfolio, Sanctum Indian Titans, we always maintain a good balance of large and midcaps in the portfolio while keeping the small-cap exposure low. Our current portfolio is 60% large-cap and 24% mid-cap. We are highly selective in small caps as a category with a current exposure of 12%.
Given the market condition, our current allocation to respective market cap segments is optimum from the perspective of risk management and return objectives. Our comfort lies in finding decent-sized companies delivering robust growth that can help the portfolio grow at a stable pace without too much volatility.
We remain open-minded on small caps and add them when the right opportunity presents itself and risk-reward is in our favor. As a rule, we don’t chase small-and-mid cap fads in good times to save the portfolio from unnecessary trouble. We often tweak the portfolio based on market and macro conditions without deviating from our risk-first portfolio philosophy.
While none of it shields us from short-term underperformance, with the right processes in place, the long-term outcome of the portfolios would be in investors’ favor.
Here is how our core portfolio strategies have performed in different time frames.
Performance is calculated using Time Weighted Returns, net of fees and expenses. Returns over one year are compounded annually; returns for less than one year are absolute. Please note that SEBI does not verify the performance information provided above. Please note that past performance is not a guarantee of future performance.