I regularly monitor index ratios like price-to-earnings, price-to-book values to gauge overall market sentiments. I know it’s a very crude way of doing it. But still it provides a decent picture of what is happening in markets.
Now here is something interesting what happened on July 7th, 2014.
Nifty 50’s P/E multiple crossed 21 after almost 3 years. Surprisingly, last it stood past 21 was also on July 7th (2011). That’s exactly 3 years back!
Long term analysis (starting end of 1998) of Nifty’s P/E ratio tells the following story…
We all know its common sense to buy low (Low PEs) and sell high (High PEs). And we also know that its difficult to do it. So if you go out and buy the index as whole when P/E multiples are less than 12 (quite low), then on an average, your probable 3 year and 5 year returns will be 39.5% and 29% respectively.
Similarly for index-buying during P/E multiples being in between 12 and 16, the 3 and 5 year returns are 28% and 25% respectively.
But we are currently in the band of 20-24. And this is not a cheap market at all. As per past data, your 3 year returns and 5 years returns look bleak at 4% and 7%.
So does it mean that we sell all our stocks and put money in bank deposits?
The answer is I don’t know.
The above numbers are based on data of past 15 years. And there is no guarantee that past performance may be repeated. Or whether this time it might be different.
The last instance of PE21, for which 3 year returns data is available (May 02, 2011), the market gave a return of 5.3%.
Similarly for last instance of PE21, for which 5 year returns data is available (June 11, 2009), the returns were 10.3%. Not bad considering the superiority over returns given by safer ones, but also not eye-popping considering the optimism we have for next 5 years.
Now we are all quite hopeful that the new Indian government, if permitted by external uncontrollable like oil-shocks, natural-disasters, wars, etc… would be able to provide a conducive environment for India’s return to high growth days.
But having said that, I also beg to differ with those who believe that this would be achieved overnight and Sensex will hit 40000 by end of 2015.
As for the current markets which are rising everyday, it seems that they are now running ahead of the actual ground realities. But it is this over-optimism that gives us, the long term investors a chance. Isn’t it? 🙂
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Awesome explanation!
Thanks Sreekanth. 🙂
Hi Ajay
This index PE is indeed to be taken as a broad indicator and as a primary step towards further evaluation. One can never make use of just one indicator for making investment decisions.
And I completely agree with you when you say that it might not be very wise to wait for PE12 days. Such opportunities are really rare and come once in few decades if not in years. If one is a dedicated long term investor, it doesn’t make any sense to try to time the markets if investing in
decent businesses. Anything longer than 10 years and you need to be in equities. Period.
And your comment rightly highlights the importance of asset allocation, which sadly I have not been able to cover in my posts. Hope to do so soon. But thanks for sharing your thoughts. It is full of useful insights.
Hi Dev,
Just came across your blog and read this post. I have been doing a similar analysis on Nifty recently and some of my observations are:
1) If you consider each day as a data point and compute forward returns (say, 1 or 5 year), then while on average (as you've shown above) the data falls into a nice linear graph (i.e. average forward 1/3/5 year return for days when P/E ratio was x – I get 96% R^2 for a linear best fit of 1 year average forward returns vs. P/E and 91% for 5 years), the overall graph is very messy with large variations in forward returns when Nifty was at a certain P/E – essentially markets can take their own sweet time to mean revert.
2) On a 1-year forward returns basis, however, markets have never given a positive return when P/E was >23.6x (including dividends), and never give a negative return when P/E was <14x. I don't see a 5-year period for Nifty which didn't give positive returns (though P/E needed to be <22.5x to get returns >10%)!
3) One interesting thing I've noted is that while Nifty's P/E is 15% above its median (18.3x), the P/B is currently at the median of 3.5x. In other words ROE of Nifty firms (P/B divided by P/E) has gone down substantially since the recession and not recovered since. I don't know if this is attributable to a change in Nifty composition or weak economic conditions or something else.
Those are indeed some interesting observations Paritosh. Thanks for sharing the same.
And I agree with you that 'averages' have a habit of hiding the actual volatility in data points. In real life, averages don't work and situation is similar to that of a student giving competitive exams. On an average, 1 out of 4 students might get through the exam. But if this particular student does not clear the exam, that average for 'him' is irrelevant.
Yes Index may revert back to mean…if earnings do not keep pace with expectations.
The market expectations is that after 5=6 years of hiatus the economy will improve. There is saying on wall street….if something cannot go on forever then it will stop. Same for market and economy.
But if that economic improvement happens then earnings, margins and profitability (ROE) of the companies will revert back to mean or even exceed. The current PE looks fair if we assume double digit earnings growth due to improved economy for next couple of years. If this assumption is proven false then market will crash for sure. But if economy and companies do better than assumed then current market level will look low in hindsight.
Personally I will give at least 3 years for the new economic cycle to play out after 5-6 years of worst recession India has suffered. Remember nothing continues forever…even the downturn.