Why Investors should be cautious of investing in the Indian stock market……

-Report By: Chirag Gothi

We are presently witnessing that period in the financial markets when disagreement is at its peak. People’s opinions are clashing with each other in a grand manner and everyone is wearing their opinions on their sleeves (with pride!). The chaos is there because of violent nifty move.

On 1st August 2017, Nifty closed at a lifetime high of 10114.65 (On an intraday basis, the Nifty a touched high of 10128.6). From that point onwards, the Nifty has cooled down.

Now the million dollar question is whether this is a small correction, which will be followed by up move again or is this a start of medium term correction (5% to 10%)?

In this article, we will discuss all the possibilities of the Nifty’s movement along with its valuation. Our objective here is to find out some kind of empirical evidence to predict the Nifty’s movement.

Let’s have a look at the Nifty PE (Price Earnings) Ratio that many smart investors widely use for cherry-picking stocks. The Nifty PE multiple is currently hovering around 26, as against a long term 20 year average of around 19. However it is lower than Jan08’s extreme of 28.

Opinion is divided whether the current PE multiple is just froth or a reasonable number.

Based on the level of PE and subsequent index returns, we observe that the Nifty index is nearing the overvalued zone at PE of 27 (Roughly two standard deviation away from the historical average!)  This happened in the beginning of 2000 as well as 2008 and even late 2010.

 

 

Based on the above chart and comment, the Nifty PE ratio definitely seems to say that the market has moved way ahead of earnings growth. However many market participants also look at the Nifty P/B ratio where Nifty is not expensive, implying that the earnings might yet not have arrived and that there are ample assets to back the prices. From the graph below, we also see that P/BV ratio is a less volatile and stable figure which after 2009 does not get impacted by the noise around the Market as compared to PE ratio.

 

 

Based on the above charts we are still not getting a clear picture and the contrast between the two valuation multiples which clearly shows that something unusual is going on and it would not be correct to decide anything based on such simple multiples!

Therefore combining the two multiples above, from the historical data sets of Nifty P/E and P/BV we may get clear picture in terms of capacity utilization.

 

The ROE is a critical weapon in the investor’s arsenal, as long as it’s properly understood for what it is and how to utilize it. Currently, the assets are still underutilized, resulting in lower profit margins and hence low ROEs. The current ROEs are still around 13.9% as against a long term average of around 19%.

However based on the traditional metric of price to book value and price to earnings; we cannot be merely assess the ROE the on current market situation. We must look at the big picture in terms of possible opportunities.

P/E is important, but it has to be looked at from a future perspective and not from a trailing one. If we consider one year forward Nifty PE based on the economic growth, demand increases and assets start getting utilized fully, the ROEs will start going towards their long-run average of 19% and it might cross 25% at the peak of the next economic cycle.

The table below of sensitivity analysis of Forward PE, will clearly point out  various scenarios to estimate the sensitivity of the Nifty to the earnings forecasts.

 

The sensitivity analysis of Forward PE of Nifty at 10,057

 

The above table shows us the consequences if we fail to estimate the growth in EPS while analyzing the market on the basis of PE. Higher earnings translate into stronger PE. However, the present PE of 25.6 is unrealistic considering the flat first quarter earnings of FY18, indicating weakness behind-the-scenes. Also the profits for Nifty firms also rose a measly 5% CAGR in the past four years, while markets saw 15% CAGR growth.

Based on the facts highlighted above, in the near future, it would be reasonable to expect that the Nifty might correct 5-7% , where investors might find comfort to infuse more money into market, having said that, we don’t see a big correction like 2008 and 2000.

In the scenario where the Nifty appreciates by 10% in next one year, then it would manage to sustain at those levels only if the earnings grew by 15-20%. Otherwise the possibility of a correction in the Nifty will keep rising and the expected correction would be deeper, especially as the P/E ratio inches towards the levels which we have already seen historically.

Another statistic worth looking at is that the Nifty has never given a good return whenever the Nifty P/E has gone above 24.

Note: Above table has been calculated based on Monthly Nifty data from 1999 to till date

Conclusion:

At times it is important to look at above the parameters where our doubts get cleared about how expensive the current market is.  As per our opinion, there is high probability to Nifty correction at current levels. Information Technology stocks may remain muted while metal and cement stocks may be the most.

When a bull run is in motion, many new investors want to become a part of the euphoria. In such a market, even stocks with poor fundamentals can deliver spectacular returns due to the hype surrounding them. So it would be wise to be extra cautious and look carefully at the fundamentals of your holdings as well as those of new opportunities. Also, it wouldn’t hurt to avoid leveraged positions due to high risk, and leave you regretting your decision to enter the market. By avoiding such mistakes can help you improve your investing skills and performance in the stock market. You can also choose to consult a financial advisor if you want to enter equity markets if you feel that you do not have sufficient time or expertise