In one of my recent posts about why I want Indian elections of 2014 to fail, I mentioned that due to recent run up in stock markets, experts were regularly coming out with one big target after another for Sensex.
Though I hate speculation, the fact is that we are all humans and its unavoidable. I hate it but I speculate every now and then. Very recently, I was fortunate enough to double my investment in MCX in just few months after company’s parent was caught in a crisis. Another stock which I believe can surprise in times to come is SAIL. I did two very detailed posts on why it was a good time to accumulate cyclical stocks like SAIL last year (2013). I still stand by that speculation. 🙂
Anyways, this post is a reaction to a report from a reputed research house, which thinks that Sensex would reach 40,000 soon. (Source)
|Such Headlines are becoming common these days (Read: rising markets)|
If they had said 5 years, it would have meant a reasonable growth rate of 12.5% from current levels of 22,500. And this would have seemed quite achievable considering that chances of India getting a good, business-friendly political environment for next 5 years are pretty high.
But according to the news item, analysts of this research house feel that Sensex would reach 40K in less than 2 years!! (Between 18 and 24 months to be precise)
This means a compounded annual growth rate between 35% and 48% for this period.
Is it possible?
I think it’s a little too optimistic and the research house is being Irrationally (Very) Exuberant. The current P/E multiple for indices like Sensex and Nifty stands at 19. And in case this target of 40,000 was to hold true by end of 2015, it would mean that earnings of constituent companies would have to grow at a rate in excess of 40%, just to keep the P/E of index at 19. And that too for two consecutive years!!
Now here we need to note two things:
- P/E ratio of 19 is not cheap.
- Earnings cannot grow at 40% for two consecutive years (Its not impossible, but its very tough)
Now, P/E Ratio for stocks (and indices) are calculated using below formula:
|Formula used to calculate P/E Ratios|
So, in case earnings (denominator) don’t grow by 40%; but index (numerator) continues to grow at a rate in excess of 40%, then this would result in expansion (increase) in P/E ratio. This would mean that Sensex would become more expensive than current P/E ratio of 19. And stock market history tells that P/E multiples in excess of 20 to 24 are unsustainable and markets correct after reaching such levels.
But does it mean that Sensex cannot reach 40K in next two years?
No. Anything is possible.
But common sense says that its better not to believe the so called expert opinions which sound to good to be true.
What do you say?
|Indian Elections 2014 – To decide course of markets for next 5 years|
|Common Newspaper / Online New Site Headlines|
|Markets Making New Highs. Reasons? Unknown.|
|Power Stocks : Deja Vu??|
- In 2008 (Jan-Feb), Sensex was trading at multiples of 24x. As of today (Jan-Feb 2013), Sensex is closer to 19x.
- Reliance Power did not have any assets at the time of IPO (2008). On the other hand, NTPC (2013) has an installed capacity of about 40,000 MWs.
We should pray that similarities end here itself. This is because if what happened after Reliance Power’s IPO (Great Crash of 2008-09) gets repeated in 2013, once again there would be massive erosion of investor’s wealth and confidence.
|Click to enlarge|
- Average 5 years returns have been a good 11.8% pa. i.e. if you invested some money in index (Sensex in this case) and did nothing for next 5 years, your money would have grown at a rate of 11.8% every year (Doubling in just over 6 years).
|Click to enalrge|
- Average 10 years returns have been a good 10.9% pa. i.e. if you invested some money in index (Sensex in this case) and did nothing for next 10 years, your money would have grown at a rate of 10.9% every year (Doubling in just over 6.5 years).
Now these two figures of 11.8% & 10.9% are not earth shattering, but if maintained for decades, they have the potential to make investor following do-nothing approach, super rich.
- In all we had 201 Five-Year Periods. Of these returns earned in excess of 10% were 91 of those periods. i.e. 45%
- The buy and hold strategy (for 5 Years) beat long term average of 11.8% a good 37% of the time.
- For Ten Year Periods, we had a fewer 141 periods. Returns earned in excess of the long term average of 10.9% were a brilliant 59% of the time. i.e. If you stayed invested for 10 years and did nothing, chances of beating the long term average were a high 59%.
And you thought that buying and holding did not work! 🙂