With the continued bear market in India and the bleeding portfolios of all the investors, many are of an opinion that things can’t get better. But if we look at history, markets always has moved in a cycle. One way to track these cycles is to look at the valuations of the market. I will explain more in the blog ‘Valuation & Market Cycles’.
Looking in the hindsight, there have been lot of signs that could have warned us to exit much before the cycle got ugly. Some of which were:
1. Very high valuation
2. Trade war: Leading to drop in commodity prices
3. Market cycles: Market don’t go in one direction. It moves in cycles.
In this blog I will be dealing only with valuation and the market cycles.
{Price to Earning- PE}
Valuation & Market Cycles- Valuation
When the valuation goes very high, the market looks for reasons to fall. It is more to do with psychology where everyone wants to book their profits. Usually, market peak is made by good corporate performance which reaches a level that performing beyond that is a challenge.
Valuation & Market Cycles- Market Cycles
Market moves in cycles. The cycles are asymmetrical given the human psychology involved. Implying the length and width of this cycle can’t be determined. At good times, we extrapolate things and fear missing out on the expectation of the continued rally.
Having seen the pain of such extrapolation, we need to accept the cyclity of the market. Things are always blurry at the end of a bear market or the start of a new phase of the market. But valuation ratios such as PE ratio can act as an indicator.
BSE Midcap Index- Historical PE
Fig.1- BSE Midcap Index historical price to earning(PE) ratio
Let me first start with the Midcap Index. Many of us were troubled by the continuous fall in small and mid-cap stocks since Jan’2018. Now, let us look at what was the Price to earnings multiple for MidCap in January 2018. It was around 45-48 which was very high compared to historical data. Anything between 25-30 seems to be reasonable for such companies. {For Small-Cap index I don’t have credible data.}
One can say if the PE can go from 30 to 48, it can go to 70 or 80. Yes, that is possible, the market can remain irrational for a long time, but it is better to be safe than sorry. The key learning I have here is to control your temptation and to be partially in cash.
I mean, if you are aware that market moves in a cycle and things are getting too rosy, it is advisable to book gradual profits. The market is supreme and if we know how it behaves and acts accordingly, we have better chances of outperforming them and that too comprehensively.
In case I have known this, I would have preferred to sell at around 40 PE and then re-enter slowly much later.
You can check the valuation of indices here: BSE Index Valuation
Valuation & Market Cycles
Historical PE difference between Midcap index and Sensex
Let me present another data point, which is the difference between the PE of Midcap and Sensex.
Fig.2- Historical difference between BSE Midcap Index PE and Sensex PE
Another indicator is that we can look to judge the current valuation of the market is the difference in valuation between Midcap index and Sensex.
Historically, Small cap will be higher PE than Mid cap, which would be higher than Large cap stocks in good times. This is more to do with the growth factor of these companies.
As you can see in Fig. 2, the valuation difference between Price to Earnings ratio of Midcap and Sensex indices in Jan 2018 crossed 20+, which was very high compared to whatever historical data I have.
The current difference of around 2 implies a very reasonable valuation for Midcap. And with the kind of beating the small-cap has taken, it will be much more cheaper.
Historical Sensex PE Data
Let’s check the PE for Sensex since 1991.
Fig.3- Historical Sensex PE
While the other indices have dropped, Sensex has gained in the very recent past. But post the budget’2019, it has started to fall. It has fallen from 29 to 27 but it needs to correct further to factor in the current realities of business in India as well as for being a reasonable buy.
Fig.4-Different PE scenarios for Sensex
Based on historical trends, once the PE of Sensex reaches 25 and is moving upwards, we should get cautious. Usually, Sensex falls the last as quality and proven names hold the ground till they cannot. If you look at the table above(Fig.4), the probable values of the Sensex at different PE ratio. Now, if it drops below 20, the value of 27,870 looks scary but it has happened in the past. Just to give you a recent example towards the end of October the PE fell to 21.3 at around 33k.
Another aspect of the rise and fall of Sensex is the current role of DII(Domestic Institutional Investor). Their investment pattern seems that their job is only to support the Sensex/Nifty by absorbing the selling by FIIs. That in a way might not let the index fall too much. But, given the high valuation, I doubt they can support the Sensex for long.
Rebased Indices
Fig.5-Rebased Nifty, Midcap & Small Cap index
In Fig.5, I have rebased the three indices(Sensex, BSE Midcap, and BSE Smallcap index) to 100 as on 1st April 2003 to give a comparative analysis. As seen in the graph, during good times Small cap gives the maximum return followed by Midcap and then Sensex. But the rule of nature comes to play that if something goes up the most, falls the most.
As seen in the graph, the three indices fall to similar level before rising again. Once the Sensex falls further, quite obviously Midcap and small-cap will also bear the burnt.
There is another scenario if something has moved up at a high level and are not falling due to one reason or the other, market or a stock price remain at that particular point/level till the earnings catch up to the price. As we have seen in the dormant period between 2010-2013.
If we can control our temptations, follow a few basic rules, we can be better prepared as we can’t control external factors but we can control our decisions.
The market will always move in cycles, we need to benefit from them. If you have read newspapers in 2013, it was the general consensus of doomsday, but the market recovered remarkably. Every time the bear market is caused by some different unknown factor similar is the unknown bull market factor.
BSE indices key stats:
Further reading: