# Why I’m not selling everything…yet

“So are you selling everything?” was a question I got recently. A fair question since this person had just finished scrolling through two of my recent posts, five charts that should worry equity investors and what that might mean for returns in 2018.

Markets rarely stay at elevated Price-Earnings valuations for long periods. The NIFTY has been at PEs higher than current on only 35 days in 19 years of trading (yes, I counted) while NSE500 has spent just 19 days at valuations at or higher than current. You can find a more detailed analysis in my guest post on capitalmind.in.

Based on all this, my quick-reacting risk-averse lizard-brain (or System 1) tells me the bottom is about to fall out and I should be selling everything and moving to fixed income (FDs or Debt Funds).

But I’m not. Not because I don’t think markets are overvalued but by taking a step back and thinking probabilistically about likely outcomes for 2018 and beyond.

**Probabilistic or Bayes Reasoning**

Probabilistic reasoning is the process of starting with an “initial” belief then adding “new information” to arrive at a “new and improved” belief. It is also called Bayesian Reasoning after Thomas Bayes, an 18th-century mathematician who came up with a simple yet elegant formula to apply to uncertain situations.

Let’s apply this style of reasoning to the question of whether markets will rise or fall in the next year.

- Start with an initial verifiable belief, call it x: The likelihood that markets will decline sharply, in any given year
- New evidence, current market valuations are much higher than usual i.e. High P/Es
- Since history says high P/Es rarely last, one of two or both need to happen:
- y: Likelihood that markets will correct significantly from here
- z: Likelihood that earnings will rise across the board thus reducing P/Es to reasonable levels

Bayes Theorem allows us to use the above quantities to arrive at a new-and-improved belief

x’: The likelihood that markets will decline sharply in 2018

**Bayes Theorem says: x’ = x * y / [(x * y) + z * (1 – x)]**

First, let’s put values to x, y and z:

**x: likelihood that markets correct significantly in any given year**

Since 1999, the NIFTY has given negative annual returns 29% of the time. If we consider negative 10% as a correction, that number falls to 16.5%. The number for NSE500 is similar at 17%

x(NIFTY) = 16.5% | x(NSE500) = 17%

**y: likelihood that markets correct significantly given a high PE**

This one is trickier because markets spend very little time at high PEs like now.

- Median NIFTY PE is 19.2, 75th percentile is 21.7, 90th is 23.6,
*Jan 19th, 2018: 27.4* - Median NSE 500 PE is 18.6, 75th percentile is 21.8, 90th is 25.7,
*Jan*19th*2018: 32.9*

We’ll consider the 90th percentile as the threshold for high valuation for this analysis

The NIFTY closed 288 days with a P/E > 23.6. Of these, 235 days resulted in returns < -10% i.e. 82%

The NSE 500 fell more than 10%, 57% of the time when valued more than 25.7x earnings

y(NIFTY) = 82% | y(NSE500) = 57%

**z: likelihood that earnings grow significantly thus reducing PEs**

As of 19th Jan 2018, NIFTY is at 10,894, PE of 27.44. This implies Earnings of 397 (Price divided by PE)

If the NIFTY is to maintain it’s current level but for PE to reduce to the 90th percentile: 23.6, implies earnings growth of 16%

Over 19 years, the NIFTY has delivered earnings growth of 15%+ in a quarter only 4.7% of the time, 10%+ only 9.8%. Similarly, for the NSE500, that number is 12%

Assuming conservatively that anything above 10% growth will satisfy markets enough to avoid a correction:

z(NIFTY) = 10% | z(NSE500) = 12%

Plugging values of x, y and z into the formula:

x'(NIFTY) = 62% chance of a correction > 10% over the next few months

x'(NSE500) = 49%

Similarly, plugging in likelihood of other levels of correction

Therefore, my revised belief is that there is a *strong* possibility of markets ending lower than where they started the year and the chances of a correction of more than 10% are significant, but not with as much certainty.

Given steep corrections are rare in general, my strategy over the last month has been:

- Reduce exposure to stocks that have run up far ahead of fundamentals
- Great opportunity to exit low-quality stocks or stocks that worsened fundamentally
- Hold (but not buy more) stocks that have strong fundamentals
- SIP into MFs investing in international markets that are still relatively cheap

Caveat: My implementation of Bayes elegant formula could well be flawed, if you know why, please drop me a note and I’d like to learn where I went wrong

Further Reading:

How Bayes’ Rule can make you a better thinker – gizmodo

Pingback: Why I’m not selling everything…yet - For Indian Investor

Will the fact that the Fed is increasing rates and reducing its balance sheet, and that the other central bankers i.e ECB and BoJ are indicating they MAY follow, impact the markets in 2018? If yes, should it be taken to account in the above calculations? This without taking into account what PBoC may do. They might lift all boats with their actions like in 2008.

Which MFs for investing into international markets ?

There are a few: PPFAS for 35% exposure to US stocks, Edelweiss Greater China Offshore and HSBC Brazil for other countries. More here: https://economictimes.indiatimes.com/wealth/invest/benefits-of-mutual-funds-that-invest-abroad-and-whats-on-offer/articleshow/59298260.cms

Note: A lot of these funds are classified as “Fund of Funds” because they invest into an international fund that then invests in the country’s benchmark index. So their tax treatment is different, LTCG only applicable after 36 months. PPFAS is an exception because they invest 65% in Indian equities and are like a regular equity MF.

The factors you’ve mentioned other than PBOC uncertainty appear to strengthen the bear case for equities.

Agree with the strategy. It’s not always easy. I’ve toned down asset allocation from 90% to 60% stocks, but don’t want to go any lower. International diversification sounds good, and PPFAS is one option – but they are only 30% international.

I sorely miss Vanguard in India. U.S. valuations notwithstanding, and with absence of Vanguard, what’s your view on ICICI and Franklin U.S. funds? I would certainly like to keep 20-25% in U.S. market in the long run..

One of the reasons cited for the run up is the lack of alternate investment avenues to compensate for low returns from other asset classes and in the present context interest rates on deposits for individuals. would there be no impact in the event of a increase in inflation and interest rates? In the background that earnings pick up may take some time yet.

Hi, which International markets are you investing in currently? Ie, which ones are you finding cheap enough to be able to invest? Russia is cheap, but which MF will you use for investing in Russia? So is Italy, but do you have a fund that allows you to take exposure to Italian equity?

Regards,

Sam

I would love to be able to invest in Russia but you’re right, there aren’t Indian MFs that do. I’m currently investing in Brazil and China (though not as cheap but relatively much cheaper than India)

Hi, have you explored the possibility of investing abroad directly? Or will opening an account with Interactive Brokers/Charles Schwarb/TD Ameritrade be too painful a task?

Kind regards,

Sam

I have considered it except the fees were too high considering the amounts I’m comfortable investing overseas. You should check out icicidirect, they have a tie-up to open an overseas trading account.

Will check with ICICI Direct, thanks for sharing.

Cool. If you come across a cost-effective mechanism to invest overseas, do share 🙂

Will certainly do that.

“Hi, have you explored the possibility of investing abroad directly? Or will opening an account with Interactive Brokers/Charles Schwarb/TD Ameritrade be too painful a task? Kind regards, Sam”

“I have considered it except the fees were too high considering the amounts I’m comfortable investing overseas. You should check out icicidirect, they have a tie-up to open an overseas trading account. ”

check this one : https://www.lynxbroker.com/

NO FEES ON INACTIVE ACCOUNTS; only smaller fees on trading actions ($21 for a $5000 share buy investment, $1.75 per option contract trade), no fees on open portfolio positions, no monthly fees, this broker is home based in Holland, and divisions in many other countries, and is an Interactive Broker order pass-through for those people living locally outside the USA. The reason they are cheaper than IB, is that given the thousands of daily orders going through their relay systems towards IB, they are a no fee client directly at IB, and only get invoiced the relayed trading costs + a commissiong you pay for them, so that they also make money.

I am trading there. All automated stuff. Cost nothing to become a client, all automated, and then you are operational, for international trading outside india. Since they are an E.U. based operator, all client funds up to 20 000 Euro per account are protected by an E.U. protection insurance system.