Double Check. A better way to evaluate Indian stocks?

The quest for the right measure to understand if stocks are expensive or cheap is an ongoing one. While judging the market’s valuation with the aid of the price-to-earning (PE) ratio is the most popular and widely followed method, it has its draw-backs. The denominator, earnings, captures the performance of just one-year, distorting the ratio in periods when profits are volatile. The ratio is also impacted by the variations in inflation that cause both prices as well as earnings to move up or down sharply.

Benjamin Graham and David Dodd had suggested a way out of this problem in their book, Security Analysis . They had said that company earnings can be smoothed over the past five or 10 years to ensure that the PE ratio is not unduly influenced by cyclical down-turns or one-off events. Robert Shiller, who won a Nobel Prize in 2013 for his work on empirical analysis of asset prices, suggested using 10-year moving average of real earnings to arrive at the price-earning ratio.

Shiller’s PE ratio, which is a cyclically adjusted price-to-earning ratio (CAPE), is quite popularly used to track the valuation of the S&P 500 in the US.

Shiller and Campbell used empirical data since 1881 to compute the yearly cyclically adjusted price earning ratio of S&P 500. They found that it is possible to estimate the returns that can be expected from the market over the coming years based on where the CAPE is. The historical mean of the Shiller’s PE is 16.7. It was found that if the CAPE moves too high above the historical mean, a reversion to the average takes place due to a) adjustment in the stock prices b) dividend pay-out or c) business growth.

Since 1881, Schiller’s PE has mostly ranged between 7 and 25. The 25 level was crossed only few times in the last century — in 1929, 1999 and in 2007. With the S&P 500 currently at 27.5, the index is said to be overheated on a cyclically adjusted basis, making the return expectations for the coming years negative.

There have been studies done on applying the Shiller’s PE ratio on indices in other global markets; they were found equally effective in other markets as well. The main hurdle faced while attempting to compute a cyclically adjusted price earning multiple for Indian markets is the lack of sufficient data.

While Shiller could work with stock index values and PE for over 100 years, the stock indices in India do not even have a 50-year history. The new consumer price inflation index has data going back to 2011 only. We have to depend on the Ministry of Labour’s CPI index for years prior to that. The data-set was also limited by the non-availability of index PE numbers prior to 1998.

Therefore, we used the Consumer Price Index for urban workers computed by the Labour Ministry to adjust the price-earning ratio of the Sensex to arrive at the cyclically adjusted PE ratio for the Indian market.

We smoothed the earnings using five-year moving average, as suggested by Benjamin Graham. As per this calculation, Shiller’s PE for the Sensex towards the end of October 2016 (the last data point available for CPI) was 22.49. This number is below the mean of 24 derived from the CAPE ratios between 2002 and 2016. Sensex’ five-year CAPE gave a warning signal towards the end of 2014, when the value touched a high of 25.3. It can be seen that the index returns tapered off from that point with the index currently trading 5 per cent below that level.

Another signal of over-heating was received towards the end of 2010 when the Sensex’ CAPE hit a high of 26.5. The Sensex peaked at 20,552 then and it took the index more than two-and-a-half years to surpass that level.

Irrational exuberance was observed in 2006 and 2007 when the CAPE was 32.7 and 39. That was the peak of the bull market and, clearly, prices had moved much faster than the underlying real growth in earnings of the past five years warranted.

Going by past data, a sharp correction or prolonged period of under-performance appears to follow only when the CAPE crosses 25. The Sensex’ CAPE towards the end of October 2016 was 22.4. This is 6 per cent below the mean recorded since 2002.

While the Sensex isn’t as cheap as it was in 2008 or 2002 when the CAPE reading was 15, it does not appear over-heated either.

There are however many detractors of the CAPE, who say that it is far from flawless. With the changing composition of businesses in the S&P 500 or the Sensex, it is argued that the rate of growth in the former years might not be applicable in the coming years. While manufacturing companies dominated earlier, BFSI and tech companies, especially the dotcom ones, rule the roost now.

These services companies have a different growth rate and enjoy higher valuation.

Similarly, changes in accounting are also said to be causing a structural shift in earnings growth that can make a mean value of the Shiller’s PE not quite relevant. There is also opinion that bond yields that are currently close to zero in the US now, could also be skewing this number.

As if to prove the detractors right, the Shiller’s PE ratio moved above 24, a level surpassed only twice in the last 100 years, in 2014. But despite increasing voices of caution, the S&P 500 index has not lost too much ground from those levels and continues to get more expensive.

In the Indian context however, the Sensex CAPE might serve as yet another tool that helps us evaluate the state of the market.

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