Are 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.
t 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 hersomething ‘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.
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.
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.