Market Correction LTCG Tax, Global Factors and Future

Sanjiv Mehta  |  2018-02-06


Indian budget was on Feb 1, 2018 when Sensex was trading close to 36100 and now on the morning of Feb 6, Sensex level is 33618, a decline of 6.87 % in just a few days of trading. A major highlight of the budget was the introduction of long-term capital gains (if you have held equities for more than 1 year, gain is classified as long-term capital gain) tax of 10% on equities as compared to existing rate of zero.  However, the gains have been grandfathered implying that gains till Jan 31, 2018 will not be taxed. For example, if you bought the equity of Rs 100 on Jan 3, 2017 and its value was 120 on Jan 31, 2018, there is no tax till 120. Suppose you sell it for Rs 135 on Nov 15, 2018, the tax will be Rs 1.5 (on capital gains of Rs 15 from 120 to 135) and you will receive Rs 133.5.

Market Behaviour & Corrections

In every note, I point out that in all stock market up moves, the ascent is never a straight upwardly sloping line. There are many corrections on the way. Sometimes, markets move ahead of fundamentals and then fall, sometimes they go down below the mean ( a level dictated by fundamentals ) and that becomes a buying opportunity- eventually, there is always a tendency to revert to mean,  But as Peter Lynch, legendary fund manager of Fidelity Magellan says that since we cannot predict the timing of correction and if we have a conviction that economic fundamentals will keep the bullish trend intact, therefore we have to be in it to win it. Returns of 5 years can be explained by the market gains of about 60 days and those days cannot be predicted, therefore to take a substantive benefit of a structural up move, we have to be present in the market but in such a way so as to create resilience to withstand corrections.

Reasons for this Correction

LTCG tax was definitely a trigger for the Indian markets but since the existing gains were protected and grandfathered, there was no particular advantage to heavy selling immediately. Fiscal slippage also contributed and the bond yields moved up to the current 7.55. USD/ INR slid to 64.25 from 63.85.

Coincidentally, global factors appeared at the same time resulting in almost all global markets falling. For example, the Dow Jones Index of USA had a fall of 4.67% on Feb 5. High global liquidity and close to zero interest rates in USA and many other countries abroad have been responsible for driving the markets higher and any hint of this liquidity being reduced makes the market jittery. A strong USA employment report of Feb 2, Friday showing wage increases fuelled the speculation of Federal Reserve increasing the interest rates in 2018 perhaps 4 times.  Commodities are also expected to show price increases.

Correction or a Trend Reversal 

For our portfolio management, it is important to distinguish whether any substantive down move is a correction or signifying a trend reversal. An important determinant is whether economic fundamentals and earnings growth projections are intact. There if you refer to my previous note ‘ Market view 2018’ posted on Jan 26, 2018, I believe that India’s growth is expected to accelerate and earnings growth momentum is just starting to build up and the resultant conviction is this bullish trend remaining intact. Even in USA Peter Garnrey, Head of Equity Strategy at Saxo Bank credited with the right prediction of this correction is of the view that this will be short-lived. Corporate tax cuts and improved corporate profitability will again drive markets higher though 2018 is expected to give returns less than the stellar ones of 2017.

Role of Financial Planning and Setting Goals 

These corrections always motivate me to emphasize the importance of financial planning and setting important goals. Investment products are merely tools to achieve our goals and goals should be matched appropriately with right products based on the time horizon. Each portfolio should be treated in a holistic manner across the essential dimensions of liquidity, safety and yield enhancement.
Volatile but higher yielding asset classes including equities should be utilized only for goals with longer time horizons. That gives us a resilience to withstand corrections and exit at only favorable levels.

Future Steps for Portfolio Management 

  1. For money with a time horizon of more than 3 years, equity will be very good.  Money should be allocated to large cap, mid cap and small cap schemes.Although it is currently felt that mid cap and small cap are stretched, our detailed analysis shows that in the Indian market, small and mid-cap schemes deliver a much higher return over a long period of time taking into account all up moves and down moves.  Schemes have to be carefully selected with a consistent performance over varying periods of time and a good track record of alpha generation. There should be a small sectoral allocation to banking and infrastructure sectors.
  2. For money with a time horizon of 1-3 years, balanced funds with a mix of equity, equity derivatives and debt will be good, since tax treatment being similar to equity funds is better than that of debt funds. Additionally, even in a down market, they hold their value well on a comparative basis.
    10 year bond yields have increased in the last year from 6.4 to 7.3 %. Bond yields are in a neutral area but the risk-reward for a duration play in the year 2018 is still not attractive and therefore should be avoided.

  3. For 0-1 year time horizon, short-term accrual and liquid debt funds are a good alternative. For people requiring monthly income stream, an SWP (systematic withdrawal process) could be structured in a tax efficient manner.
  4. Real Estate is expected to fall and might stabilize in about a year’s time providing a good buying opportunity later. It is possible that affordable housing segment might do better. Therefore, my recommendation will be to wait and watch. In the interim, grow your savings in financial instruments which are expected to outperform.
  5. Gold- As I have always written, historical returns of Gold are very low , although periodically it does go through fairly long period s of appreciation and then can decline for quite some time-long term overall trajectory is almost flat. Therefore, invest only that proportion of savings which fulfils your real gold requirement and not as a return enhancer.