Crystal-gazing using PE ratio, volatility index

KS Badri Narayanan | Updated on August 14, 2020

While India VIX is on a slide, PER is on a high

A number of market experts and investment advisers turned uncomfortable as the price to earning ratio (PER in market parlance) of the Nifty 50 index moved past 30. In fact, ever since the PER crossed the 27-mark in June 2018, some experts have raised red flags and are even advising investors to book profit or stay on the sidelines.

However, a sharp correction in March 2020 brought the PER to 17.15-level. But within four months, it not only breached the 27-mark, but also zoomed past the 30-point mark effortlessly. Currently, Nifty PER is ruling at 31.4, a level not seen by the Nifty 50 index since its launch.

The price to earnings (PE) ratio is calculated by dividing a company’s current share price by its trailing 12-month earnings per share (EPS). For example, Reliance Industries is currently trading at a PER of 43 on standalone basis, considering the previous four quarterly standalone earnings. Nifty PE ratio measures the average PE ratio of the Nifty 50 components of the index.

Though the rising PER is threatening investors, volatility index, another metric used by traders to gauge market direction, is giving a sense of comfort.

Volatility index which zoomed to a high of 83.61 in March this year on the back of the coronavirus-led pain, cooled to 19.54 on Friday, but climbed back above the 20-point mark to close at 21.67. The current trend of India VIX signals that the worst may be behind us. The volatility index captures the expected movement — upside or downside — of the underlying index over the near term. In simple terms, the volatility gauge moves in the opposite direction to the underlying index.

Swinging fortunes

India VIX points to investors’ perception of the annual market volatility the next 30 calendar days.

The comfort zone for the volatility index is between 13 and 15. Past trends suggest that whenever the index has slipped below 13, one has to be very careful, as the market may turn volatile again. Similarly, a rise of above 60 is an oversold zone and time to accumulate quality stocks. India VIX hit an all-time low of 8.7 in May 2008 and a life-time high of 85.13 in November 2008. In March this year, it rose to a high of 83.

So, the contrasting indicators can confuse you, leaving you unsure which one to follow. Definitely, one has to give weightage to PER, which reflects the market’s fundamentals. The market cannot be far away from the fundamental level and has to readjust to the normal.

Investors, especially starters, should ignore talk of PER 28 being the new normal. The PER will have to correct, either through strong results from companies, or via price correction. While the former appears to be a rather difficult proposition, at least for the next two quarters, given the current state of the economy at both global and domestic levels, the latter is possible, once liquidity dries up.

Volatility index, on the other hand, is a short-term predictor. As the name suggests, the index could swing wildly if any major adverse development takes place at the domestic or the global level. So, VIX is the best tool for traders to benefit from short-term movements and it helps investors to identify over-bought or over-sold zones and pick good stocks for long-term investment.

However, empirical studies, time and again, have proved one thing whenever Nifty’s PER has exceeded 25, the average return from Indian equities over the subsequent three years has remained negative.

So, the discomfort is not unfounded. As the fall could be as high as 40 per cent, caution is advised to investors, whether they buy through the lump sum route or the systematic investment plan (SIP) way.

Published on August 14, 2020

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