Markets overheated? Don’t Worry – Just Start A SIP

“Markets can remain irrational longer than you can remain solvent” is one of Keynes’ most iconic sayings – it holds good even today – and quite likely will continue to hold more than a grain of truth as long as securities markets exist.

While it stands true that equities represent a fantastic medium for generating long-term wealth; it is also a fact that overheated markets can get even more overheated – and already beaten down markets can correct even further. In such situations, the ‘behavioural gap’ created by the natural tendency to make emotional decisions widens significantly, eventually resulting in widespread scepticism about equity markets as a whole.

This is where SIP’s (Systematic Investment Plans) in mutual funds can come in very handy. Because you commit small, affordable sums of money into the stock markets each month (or week or quarter), the tendency to constantly check on your investments and take irrational decisions due to greed or fear narrows greatly.

But the question that arises is this: if markets have already run up significantly, should you start a SIP or wait for a correction instead?

This question can be broken down into two parts. First, how can you gauge whether the markets, broadly, are undervalued, overvalued or fairly valued? A rather simple but effective thumb rule to evaluate this, is by tracking the current PE ration (Price to Earnings Ratio) of the NIFTY. Historically, anything under 12X is undervalued whereas any number greater than 25X signals overvaluation. Between 12X and 25X, the markets are at varying bands of moderate undervaluation or overvaluation. The PE of the NIFTY stands at approximately 23X as on date.

Interestingly, SIP’s started when markets were already moderately to highly overvalued seemed to have fared exceedingly well almost each time – provided that the investment was carried on, in a disciplined manner and with gumption, for a minimum period of five years.

The logic behind this phenomenon is easy to understand. Overvaluation, almost like clockwork, gives way to a period of capitulation that could last anything from 12 months to 24 months. This is the phase when markets revert to their mean, and swing in the opposite direction – in effect, continuing to remain irrational, just in a different way!

It is during these phases of capitulation and intense pessimism that SIP’s pack the maximum punch. Due to an interesting little phenomenon known as ‘Rupee Cost Averaging’, investors end up purchasing a whole lot more units with the same rupee amount during these market phases. The end result: when the cycle reverses and pessimism eventually gives way to unbridled optimism, portfolio returns explode.

To illustrate, let us consider the 5-year returns (CAGR) from a SIP in the bellwether Franklin India Bluechip Fund at various states of overvaluation.

• December 1999 (PE = 24.22) to December 2004: 34%

• February 2000 (PE = 28.47) to February 2005: 36%

• October 2010 (PE = 25.91) to October 2015: 15%

• January 2008 (PE = 28.31) to January 2013: 14%

• December 2009 (PE = 23.17) to December 2014: 17%

Sure, there would be situations where returns from SIP’s in a five-year period would be flat as well, but you’ll find that even in such a instances, continuing the SIP for another two years would lead to good returns. Case in point: a SIP in the same fund from march 2004 to March 2009 would have been at a flat to negative rate of return after five years. However, had the investor carried on the SIP for another two years until 2011, the overall return for the 7-year period would stand at an impressive 19.47%!

End Note: Overheated markets usually end up as great starting points for equity SIP’s. Continuing them dispassionately for at least 5 years is key. If you unluckily find yourself earning flat to negative returns even after five years, continue for another two years and your returns will likely improve vastly.