One of the problems in raising concerns about valuations is that you can end up looking like a party pooper. And if future markets movements do not happen in line with what you are expecting, you can even end up looking like a damn fool!

But that’s fine. I don’t intend to predict anything here.

It’s just that if you look at the data, it does trigger some concerns. I am a simple investor who wishes to buy low (and maybe occasionally sell high too).

Unfortunately, the ‘buying low’ part doesn’t seem to be easily happening these days.

For Nifty50, the valuation of the index today is in excess of PE-26.

Now historically, this is rare! And has happened very few times in the last couple of decades. In fact, there seems to be a sort of hidden upper ceiling when it comes to valuations and markets have trouble keeping above that ceiling.

Have a look at the chart 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.

Nifty PE Pattern Trend

Clearly, Nifty seems to have trouble staying above PE24 (considered overvalued) and below PE12 (considered highly undervalued). Whenever it reaches either of these two levels, it seems to bounce off in opposite direction!

Also, a move beyond PE 25-26 has been historically rare and generally resulted in steep falls. And as can be seen from tables below, markets do not spend a lot of time on the extremes:

Nifty PE Band Group Time

But does it mean a sharp fall or a full-fledged market crash is just around the corner?

I don’t know.

River water seems to be flowing above the danger mark. But will it flood the city or not is something that I cannot predict. And markets have this evil habit of surprising. So who knows they may remain at these levels for much longer.

Ofcourse every now and then, the valuations will be stretched and go where it hasn’t gone in last many years. But it’s important to consciously remember that sooner or later, the reversion towards mean happens. And this is what learning from history and identifying basic patternshelps you do.

I regularly publish index PE data and as many of you might have noticed, is showing a lot of red. Check here for the latest update in November 2017.

I have done detailed analysis earlier which shows (or seems like modestly predictive) that future returns tend to be low when investment is made at very high valuations. To summarize, it is something like this:

Nifty PE Ratio Return Patterns

(Please do note that above are average figures. And depending solely on averages and ignoring the actual deviations can be catastrophic. Read about the risk of depending only on averages and please… never forget about it.) 🙂

Now interestingly, the Nifty PE has remained in and around 24 for last one and a half year. And as of now, we have been flirting with PE26 and above(s) for the last couple of months.

I did some further slicing & dicing of data to see what happens to index returns (in next 1, 2 and 3 years) when investments are made in PE24 and above zones. Here is the data cut:

Nifty High PE returns historical

It’s self-explanatory and unfortunately, paints a sorry picture.

Do note that the correlation seems very strong but the number of data points is not very high.

All these hints towards something not being right. But the party still seems to be on…

Maybe, the earnings will surprise and bring down valuations without hurting market levels. Or maybe, the constant flow from retail investors is and will support the markets for longer. Or maybe this time it is ‘really different’ and we will continue to reach newer heights on the mountain of valuations.

But like all bull markets where new highs are being regularly made, it’s very easy these days to write off valuations as something of an unnecessary botheration. Everything is moving up like there is no tomorrow. Investing in IPOs is once again perceived to be a quick way to make money. But trees do not grow to skies for a reason. And valuations matter. Believe it or not.

I don’t intend to predict a big crash here.

Markets have a mind of their own and will crash when they want and not when we predict. But I feel that we should not throw caution out of the window. We should be alert. Alert to the possibility of lower future returns.

But since I have used Nifty50 PE data as a representative of the market, let’s make note of few things which should be kept in mind:

  • Nifty of today is much different from Nifty of earlier years. Infact, there is a regular change in index constituents. So it’s easily possible that high PE is the new normal. After all, in earlier years Nifty was made up of low-PE companies while these days it’s populated with high PE ones (read this interesting analysis).
  • Another aspect linked to above point is that PE data provided by NSE is based on standalone numbers of Nifty companies. It would be ideal to use consolidated numbers as many Nifty companies have subsidiaries that have a significant impact on earning numbers. This has a much larger effect now than it would have had in yesteryears. But NSE publishes Nifty PE using its own set of criterias and decisions.
  • For all practical purposes, one cannot wait for investing when valuations are rock-bottom (like PE 12-14). If that is the case, the investor will end up on many bull runs that begin at 15 and end at 27.
  • Investing in individual stocks is a different matter altogether. You can always find undervalued stocks in overvalued markets. There can be stocks that continue to command high premiums and still deliver spectacular returns year after year.

I don’t know what the so-called smart money would be doing now. But moving out of equities completely is not something that I do. Ofcourse, focusing on asset allocation with an eye on valuation and operating in preferred tolerance bands is something that should help most people.

LEAVE A REPLY

Please enter your comment!
Please enter your name here