Market cycles are a natural part of investing. They follow a circular path which may begin with a bullish phase where everything seems rosy and portfolios are booming. Gradually, valuations become frothy and the balance between growth and valuation becomes precarious. This is when smart money starts to exit the market silently, laying the foundation for a correction. Intelligent investors, not necessarily big ones, understand the market's pulse. However, for common investors, as of now, the big question on everyone's minds is: Where are we in the market cycle? Are we at the peak of the bull market, heading towards a correction, or still in the growth phase?
Over the past five months, we've witnessed significant shifts in market dynamics, leaving investors and analysts pondering about what lies ahead. There is one lot of market participants who are cautious over the past five months of extreme moves, whereas as the other side says, this is just a start of a multi-year bull run. In this article, we'll delve into the key details and data to help you understand the current state of the market and make informed decisions.
1. Quantitative Momentum as Indicator
By examining momentum heat maps for the past five years, we can gauge the market's momentum. Momentum is good for the market; but when momentum peaks out, and then reverses, market tops are created. Currently, we are near the 80th percentile from historic peak levels (Scientific Investing has used its proprietary momentum indicator).
2. Quantitative Trend as Indicator
Another important indicator is the percentage of Nifty 500 companies above their 200-day exponential moving average (EMA). Again, big money is made when this number stays consistently high (another sign of good momentum). Further, when it tops out and starts decreasing, it suggests market weakness where a few stocks might still be moving the index, but caution is warranted. Last time, in June 2021, it reached a peak of 90 but that didn't prevent the market from climbing higher and peaking three months later. Therefore, a high percentage alone doesn't guarantee a downturn; but is a warning sign.
Segmenting the Market – Large-, Mid- and Small-cap
To gain deeper insights, we can dissect the market into various segments. First, let's examine the Nifty 50 index. Surprisingly, there's no evident froth in this segment based on market momentum. It's important to note that some established giants like HDFC, Kotak and Reliance have not shown significant performance.
However, when we shift our focus to small- and mid-cap segments, where the maximum money has been made, a different story unfolds. In both cases, these segments are, currently, showing signs of frothiness, with a rapid ascent in recent months. Currently, we're near the 80th percentile from historic peak levels. The challenge lies in deciphering whether this froth is due to the market emerging from a correction or whether it signals an impending correction.
3. Quantitative Price Value as Indicator
Price is a good indicator of value at index level. In the long run, indices provide returns closer to their mean, unless in a structural upward or downward journey. Based on mean return and current standard deviation from the mean, a reasonable guess can be made regarding index attractiveness. The Nifty's three-year return is around 20%, while the five-year return hovers near 12%. These numbers suggest that, despite recent gains, the market hasn't deviated significantly from its historical mean.
However, for mid- and small-caps, the story is different again. Over the past three years, mid-cap index has delivered impressive returns, with a compounded annual growth rate (CAGR) of around 30%. The five-year return is equally notable at 18%. These figures, well above the historical mean of 12%, suggest that small-caps may be due for a return to the mean.
4. Quantitative Market Sentiment as Indicator
Another key indicator to gauge market mood is to get a sense of public greed and fear. In times, when greed dominates, the trends of finding quick and easy money dominate. Google Trends data shows increased interest in terms like ‘multibagger stock’ and ‘micro-cap stock’, which often coincide with periods of exuberance in mid- and small-caps. Again, we are not at the peak; but we are in a phase of euphoria after a major lull of the past few years.
5. Technical Analysis and Market Stretch
Usually, charts are used to find weakness, once market tops out and there is a downward trend. How to use charts to get signs of what is to come? The answer lies in looking for signs of stretch. Look at all historical tops and how much the charts stretched from a common mean which could be a moving average line based on the timeframe one is interested in. Currently, again, mid-cap, and small-cap look more stretched compared to the NIFTY, looking at their historical stretch deviations from 200-week exponential moving average line used for multi-year long-term investing cycles. There is still a possibility of 15%-20% higher stretch; but, again, that would mean again hitting the peak. Further, charts need to be monitored in the typical traditional way, in case any sign of wear and tear emerges.
6. Financial Indicators – EPS Growth and Valuation
In the long run, markets move by fundamentals -- growth and valuation. So, it is important to study the fundamental performance. The fundamental side of the market is very interesting. On one side, we had a very good last quarter year-on-year (y-o-y) results. There was 10% and 19% sales and profit after tax (PAT) growth, respectively, y-o-y which is very healthy. Market pays for growth and a continued quarterly performance can keep market in premium valuation zone. However, it must be noted that a long sustainable growth at broad market level has not been a reality. Time would tell if we are in a different era this time. Coming to valuations, which market is paying for, the valuations do not look comfortable, by any means.
Valuations in small-, mid-, and micro-caps look 25%-45% stretched from their historic mean and median values. It is again only the Nifty 50 which does not seem to have any major valuation froth building as of now. Now, though the market is being supported by good y-o-y EPS (earnings per share) growth, continuation of growth is important for valuation premium to sustain. When growth falters and price-to-earnings (P/E) ratios have already expanded, corrections become likely. It's a delicate balance between valuation metrics and growth prospects that investors need to consider.
Conclusion
Given the data, current market requires a cautious approach, especially for investments in small- and mid-cap stocks. We may not have topped out and there could still be some run up left, but the faster the run-up in small- and mid-cap, the closer we will be towards peak froth. We have already hit the zone of froth, whichever metric we look at and whichever data point we look at. The only antithesis to this is outstanding quarterly results which need to sustain to ensure such market moves are sustained. However, large-cap index still looks in the fair zone without any major bullish or bearish stand. Monitoring key indicators, like earnings growth, technical chart patterns and market sentiment, is paramount as markets are dynamic and evolving. The above analysis provides a framework to do this.
