Sounds like a title of some Technical Analysis writeup? I don’t blame you. 🙂 But rest assured it is not. Infact, this will be an entertaining post for you if you are interested in giving some thought to PE-Based investing. In previous post, I did a detailed analysis of the PE Ratio of Nifty 50 in last 16+ years.
It does throw up some interesting insights. But what catches the eye is that there are levels, which the Nifty generally fails to breach on lower and upper sides.
There is no doubt that by investing (more) in markets trading at low PE multiples, chances of earning higher future returns increase. Similarly by investing in markets trading at higher PEs, chances of lower future returns increase. It is very simple.
But to say that one can time the market on basis of just Index PE will be an over-simplification.
As we saw in previous post, the mere fact that expected average returns are high does not mean that the returns you (in particular) get, will be guaranteedon lines of the high averages. It does not work like that.
If you are unable to understand this point, I recommend reading the post – especially the example of average depth of river part.
Now I did the following analysis in 2012too. There were clear indicators then, that broader indices had a dislike for staying above or below certain PE multiples. Not much has changed in last 4 years.
Without getting into the statistical accuracy of numbers, the analysis shows that these PE multiples are PE12 and PE24.
Have a look at graph below:
The blue line is actual Nifty level.
The red line is hypothetical Nifty level at PE24 at that time.
The green line is hypothetical Nifty level at PE12 at that time.
Clearly, Nifty seems to have trouble staying above PE24 (considered highly overvalued) and below PE12 (considered highly undervalued).
Whenever it reaches either of these two levels, it seems to bounce off in opposite direction!
Though the chart might look like a screen-grab from a trader’s terminal, it’s a clear display of how fundamental this concept is. 🙂
Buy low (PE). Sell high (PE).
If you think it’s timing, then you are right.
If you think it cannot be done, then you can try this instead:
Buy low (PE). Avoid buying high (PE).
More manageable. Right?
Now ofcourse you can say that I should have used PE25 or PE11 to make it more accurate. But the idea here is not to be as accurate as possible. Rather, the idea is to become cautious when markets start moving in irrational territories. Index PE depends a lot on what are the index constituents and other factors.
So broadly speaking and ofcourse basing my conclusions on past data, PE12 seems like a clear signal that investors are unreasonably pessimistic and at PE24, over optimistic. Both are unsustainable and hence, indicate near term reversion towards mean. Though nobody can guarantee that markets will behave on similar lines in future, chances of that happening are pretty high.
Those who think that, ‘this time its different’ – have not had much success when it comes to investing. 🙂
My analysis and conviction is based on the fundamental assumption that India is a growing economy (atleast for next decade and a half). And I believe that markets are highly undervalued around PE12 and highly overvalued as they approach PE24.
But ofcourse, you may choose to differ on this and invest accordingly.
So instead of getting into this debate, lets come back to the title of the post – Is it safe to say that index bounces off PE levels of 12 and 24?
It seems to be true. But note that markets don’t stay at such low/high levels for very long time.
So inspite of being sure to invest when PE12 is crossed on the downside, you might find yourself lacking enough firepower (cash) to take advantage of the situation.
Have a look at times the index has spent at various PE levels:
Now lets aggregate these PE bands into smaller groups:
Just 1% of the time – market has stayed below PE12. Can you catch it?
Chances are high that market will catch you unaware. And believe me, market is capable of doing that beautifully. 🙂
So what should one do?
Its simple, you cannot wait for markets to fall to PE12. But you can become (more) interested at it crosses PE15 on the downside. That is more manageable. By ‘becoming interested’, I mean that you should have a thought process like this:
“Market just came down to PE15. It looks attractive. But what if it falls lower? Do I have the money to buy more if it goes down to PE12-13? I guess I should be alert and start preparing myself.”
You might ask that why am I telling you all this when PE is neither near 12 nor 24 (Currently 19)? It is because you won’t listen to me when markets are booming (PE24) or when everybody else around you is selling and running away from markets (PE12). 🙂
So keep this in mind.