While net inflows matter, they are not enough reason to add risk in the present scenario: stay cautious now
Three risks to buying on the hope of continued inflow
As the market runs out of bottom-up arguments, investors increasingly point to the strength of domestic equity flows as justification for further upside, and to dilute rationality. Flows however are a weak argument in our view for three reasons.
1) Causality: the rising market attracts inflows; 2) issuance: the supply of money will create demand, especially in a growing, and infrastructure starved country; net flows matter; and 3) real rates: household allocation to equity increased as debt returns failed to beat inflation. That argument has already turned. If inflation expectations fall now, and equity return expectations weaken, then domestic equity flows may recede. Flows are not sufficient reason to add risk at elevated valuations. Very few stocks are cheap on absolute; relative investors should look at market relative investment opportunities. Stay cautious near term.
Net inflows matter — but the correlation is not perfect
Inflows into domestic mutual funds have been very strong since mid 2014. FII flows have been fickle, and equity issuances modest. This data is not complete — there are other participants in the market. Nevertheless, there is 65% monthly correlation between net flows and Sensex monthly returns. This is not perfect — the market has historically fallen even when this net inflow number was positive. Even if domestic MF inflows remain high, net flows can diminish as issuances increase. YTD issuance is already more than 70% of CY2016. The pipeline for new equity raise is also reasonably large.
Can domestic inflows stop?
Real rates have already turned positive with the recent collapse in CPI. The risk to domestic inflows then is a combination of falling inflation expectations and declining equity return expectations. While it may seem unassailable now, the income tide of domestic liquidity can reverse.
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Stay cautious now
The safest or easiest forecast one can make at any point is to argue that the status quo will continue. Unfortunately with sufficient time that has generally proven incorrect. Buying stocks at all-time high valuations on the assumption that domestic flows will continue ad infinitum and insure from downside may be dangerous. Timing a correction is difficult; many investors still need to buy. Such investors should risk now. Stretched multiples are a near term risk. December 2017 Sensex target of 30,000 implies downside. Prefer financials.
— BofA Merrill lynch