Are Indian Stock Markets Overvalued?

Indian stock markets have moved up quite a bit in last few months. Not only in absolute sense, i.e. index levels but also in terms of valuations.

Last I checked, the bellwether Nifty50 was trading at a PE of 24. And such high PE levels are known to cause losses in medium term. Here is a solid proof.

But don’t jump to any conclusion here.

The Indian stock markets are overvalued right now, no doubt. But there are few other things that should be kept in mind too.

It is increasingly becoming evident that the average investor has got back his interest in stock markets. And when that happens, it can have negative impact on near term returns. 😉

But jokes apart, almost everything seems to be going in favor of markets – low oil prices, good monsoons, chances of lower interest rates, passage of GST bill, FII inflows, etc.

Average investor fears missing out on big returns and want to join the market action.

Unlisted companies are using this FOMO (Fear Of Missing Out) syndrome to come out with their [Always] Overpriced IPOs (which is not abnormal – IPOs always come in rising markets). Then AMCs are celebrating SIPs like festivals. But credit should be given to them as SIP is indeed the best way for retail investors to create long term wealth from stock markets.

Also, there is a lot of consensus about almost everything that is being said with a positive bias.

Everybody seems to be under the impression that its easy to make money in stocks. Apply for and IPO and Yo! – guaranteed listing gains! Even my wife was asking me one of these days to buy her something ‘golden’ as she recognized the dominance of green color in my portfolio. 😉

Lets come back to the PE discussion for a moment. I told you that Nifty50 PE is above 24. Have a look at this graph:

This is a graph where I have plotted actual Nifty level (blue line) and hypothetical Nifty levels at PE24 (red line) and PE12 (green line).

If you observe carefully, the blue line seems to bounce off whenever it is about to touch either the red or the green line (bounce points highlighted by red and green circles).

Also, if you notice that big red arrow – that is our markets now. We are once again flirting with PE24 levels. So danger lights are on.

I know, this graph makes me look like someone trying to use technical analysis to draw out fundamental conclusions. But it is clearly evident.

Suggested Reading – Does Nifty Bounce off PE12 and PE24 Levels? 

Chances of markets sustaining above very high PEs is very low. There is always a reversion towards the mean (i.e. lower PEs in this case).

But don’t think that this should be the only criteria to assess market valuations. Also, simply basing your individual stock buy/sell decisions on broader market indicators is wrong. Its infact criminal!

But you need to be aware of what is happening in markets. And tracking few of these indicators (like I do in State of India Stock Markets every month) can be quote helpful. Atleast you are not taking decisions blindly.

 

High PE is No Guarantee of Stock Market Crash!

Yes. Just because markets have a high PE doesn’t mean that markets will crash.

Why?

PE Ratio = Price / Earnings

So if price (index level) remains same and earnings increase, the PE will naturally come down – i.e. valuations can come down even without price correction.

Talking of earnings (of all companies that are part of index), it is worth asking how are these companies doing on earning front? Or what are the projections for near term.

Most people expect and believe that earnings will improve going forward. One of the reasons being given is that the groundwork done by government in last two years has set the stage for revival. Then banks NPA mess will finally be over and interest rates will fall and this and that and what not….

So if earning do indeed improve, the markets will become reasonably valued without even a correction.

But if earning do not improve and given that valuations (expectations) are already very high currently, we cannot rule out a correction – small or large, I don’t know.

A fall of even 10% in short term is not rare. I personally will welcome such a fall if any. 🙂

But markets have this uncanny habit of doing what nobody expects them to. There won’t be any correction when most people are talking about it. But the correction (or crash) will take place when most people aren’t expecting it.

As of now, the general perception is that near-term future is bright. So if markets were to surprise this general perception, it should fall. Now I think that Indian stock markets are overvalued in general (driven by hope that earnings will improve) and a correction here will be healthy. So if markets were to surprise me instead, they would ignore me and continue rising. My bad luck then. 😉

But don’t forget that a good part of the recent upmove is fueled by FII money. And they can very quickly move in or out of the market – driven by news or other factors. So an abrupt fall in our markets, if FIIs decide that ‘enough is enough’ should not come as a big surprise.

 

What about other indicators (like Price/Book Value, Dividend Yield, etc.)?

If we just look at the numbers, all these indicators say that markets are overvalued.

I have already written about it recently. So you can go through following two articles and draw out your own conclusions

1. P/E, P/BV and Dividend Yield Analysis – August 2016
2. Relation between Returns & index P/E
3. Relation between Returns & index P/BV
4. Relation between Returns & index Dividend Yield

Some people talk about the Market cap to GDP ratio – a concept popularized by Warren Buffett. He is known to have said that this indicator is ‘probably the best single measure of where valuations stand at any given moment.’

This is calculated as follows:

Market Cap to GDP = Market Capitalization of country’s stock market / GDP of the Economy

So it requires two inputs – 1) Market Cap and 2) GDP.

Market Cap is easily known.

But even though GDP numbers are easily available, there are questions to be asked about reliability of the GDP data. There have been times when almost all other indicators have pointed in one direction and GDP growth rate pointed in other. So I don’t have a very high conviction on GDP numbers being published currently.

Due to lack of conviction here, its tough to use Warren Buffett Indicator (which makes use of GDP) to draw out any conclusive signals. So I prefer not to use Market Cap to GDP Ratio of India to discuss about stock market’s overvaluation or undervaluation.

Before we move forward, lets try to play devil’s advocate here. Since start of this article, I am trying to convey the message that markets may be overvalued. But for a moment, lets invert this discussion..

Can we somehow prove that Markets are not overvalued?

Lets try doing that:

It is true that before 2014 elections, Indian economy had one foot on the brake and other on the accelerator. So with high interest rates, high inflation, high crude oil prices, low demand and low capex, growth was sluggish. So this muted growth obviously didn’t lead to earnings growth.

And since Nifty PE looks at trailing earnings, the valuations do seem to be expensive.

But as I said in first few paragraphs of this article, there are a lot of things that are in favor of Indian now (low inflation, falling rates, GST, etc.). So if these favorable factors, combined with government’s push to give a boost to economy do actually work out, its possible that earning might grow more than expected. As a result, the valuations will come down and markets may make new life-time highs.

Now re-read the previous paragraph and observe the underlined words. A lot of if(s) and but(s) and might(s) and may(s). 🙂

So just too many things need to work one after the other. Its possible… But you know what I am trying to say here…

 

Looking Inside The Box When Everyone is Looking Outside the Box 

Successful investors do what others aren’t doing.

It is very simple. Not easy ofcourse.

But let me be frank here – even though markets in general are not cheap, there are still pockets where undervalued stocks are available. But ofcourse, its not easy to simply go and find the most undervalued stocks in India just by looking at some financial parameters. The answer to the question ‘how to find undervalued stocks or companies’ is not an easy one.

I wrote an article titled Don’t ignore large caps. Its primarily about looking in places where other aren’t.

When most investors are going after fancy names and following stock gurus, it might make sense to take step back and look into the opposite directions.

Sometimes value sits in front of our eyes and we ignore it because everybody else is doing so.

We need to stay on a lookout for businesses that are being neglected, are out of news or in news because of wrong reasons. It is only then that we will get a good price (low price). You cannot get good news and good price simultaneously in stock markets.

 

What I am Doing Now? 

Now its easy to quote someone like Charlie Munger here

Move only when you have an advantage. It’s very basic. You have to understand the odds and have the discipline to bet only when the odds are in your favor.

But it is difficult to implement it. We have our financial goals and other things that require our attention in life. Unlike lord, we are mere mortals 🙂

So what should you do?

Every man for himself. So before I give some uninvited advice about what others should do, let me first tell you what I am doing.

Now you don’t have to do what I am doing. I can take risks that you might not be willing to or shouldn’t. Given my background, I can (atleast try to) act as I talk about buying low and selling high and having a market crash fund. 🙂

And here is a graphical guide that helps me keep a cool head when it comes to investments.

You can read more about this guide here.

So as far as I am concerned, I want to strike the right balance between optimism and caution. And that is damn tough, honestly.

But I try to deal with it at two separate levels:

Strategic Portfolio + Tactical Portfolio

What is my Strategic Portfolio?

I am a common man. I have common financial goals that need to be fulfilled at all costs. And I don’t want my stock market predictions or flawed assumptions to come in way of my goal achievement. Plain and simple. So Strategic Portfolio is where I invest for my financial goals like financial freedom, etc.

To put it more simply, I can afford to not be a great investor in my strategic portfolio. But I cannot afford to be a bad investor in this part of my portfolio.

Read that again. 😉

In this part of my portfolio, I continue to invest regularly in equity funds that I have chosen. I also invest in PPF and debt funds to maintain the overall asset balance of this portfolio. Since I believe that markets are overvalued right now, I will not put additional money in equity MFs here. If I have surplus, I will either stay in cash or push it in debt.

To summarize, base SIPs in equity funds continue. Investments in debt continue as per plan. But no additional investments (if surplus available) in equity linked products for time being.

Suggested Reading: 19 Practical Tips Suitable for such a Portfolio

Now,

What is my Tactical Portfolio?

Here I take slightly riskier bets with my money. No, I don’t borrow and invest. But I am comfortable taking additional risks in an effort to get higher returns. Again since my reading is that markets are overvalued, I am holding back my guns and not doing much here. Infact, I have sold some of the stocks from my non-core holdings.

To summarize my portfolio structure approximately, here is a graphical depiction:

I know what you must be thinking. I am holding my new investments (in tactical portfolio) and sort of being in cash, liquid funds and sitting out. What if I miss the rally (if that happens in near future)?

If that happens then so be it.

I can’t be right everytime.

Isn’t it? Nobody can.

I know that I run the risk of losing out if markets go against me. But I am doing what I am comfortable doing. 3 Cs of Cash + Courage + Crisis drive me.

Its very simple for me –

If markets go up, I am uncomfortable. If it goes down, I am comfortable.

I would love to see markets go down. You already know that I pray for market crashes. 😉

So moving on.

Caution – Do not take any actions solely based on what has been written above or more importantly, after this sentence. Your money – Your responsibility.

 

What Should You Do?

First, spare a moment for this – History of stock market is full of examples where returns have been poor when everybody was thinking that returns will be great (latest example: 2007-2008).

As of now, I don’t know whether everybody thinks like that. But given what indicators tell, most people are quite optimistic (and may be over-optimistic) about future returns.

A solid 15% CAGR is like a no-brainer for most people – which they claim they can easily manage. To be honest, its hilarious to know such opinions. 🙂 And this reminds me of a beautiful quote that Warren Buffett came up with in his letter to investors in 1997:

In a bull market, one must avoid the error of the preening duck that quacks boastfully after a torrential rainstorm, thinking that its paddling skills have caused it to rise in the world. A right-thinking duck would instead compare its position after the downpour to that of the other ducks on the pond.

So if I were you, what I do going forward will depend broadly on my time horizon and whether I am interested in lumpsum or regular investments. Specifically speaking…

• I would let me SIPs continue that are directed towards my financial goals. No tinkering with that (atleast not now).
• I will sell stocks that I know are crap but part of my portfolio.
• I will have watchlist of stocks, which I will buy if markets do fall from here.
• If my portfolio is already equity heavy (due to run-up in prices) and if I have surplus funds, I will hold on to it or put it in debt for time being. I will wait.
• But if you have surplus and don’t need it for years, you can take a simpler route to invest that surplus .

I know its easy to say all this. But when markets around you are going up, its tough to leave the party.

But I am telling you, its best to leave the party when you don’t want to. 😉

Even after writing all this, don’t for a moment think that I have any special ability to predict anything. And as Jason Zweig says in this article,

Don’t let anyone (else) fool you into thinking that history or mathematics can identify some exact entry point at which you can know you’re buying back into stocks at a bargain level.

Also, when returns in recent past have been high, our awareness of increased-probability-of-lower-future-return decreases. But we must not forget that in markets, risks increase with increase in prices.

So the party is on. Be happy that markets are doing well. But combine this happiness with a bit of caution. Stock markets are overvalued and a little bit of caution won’t hurt you. Infact, it will protect you. A correction in 2016 or 2017 may not be as severe as crash of 2008 and 2009. But if there is no correction without any earnings improvement, it will be a bit surprising.

As for the crash, I have always maintained that stock market crashes are good opportunities for long-term investor to give booster shots to their portfolios. So have patience. 🙂

And as Warren says,

Be Fearful When Others Are Greedy and Greedy When Others Are Fearful.