Valuations out of comfort zone: What you should do now

A famous law in economics -- Stein’s Law-- states, “If something cannot go on for ever, it will stop”.

With the Sensex touching the 50,000 mark last week, one thing on every one’s mind is this - will the exuberance continue or will the markets succumb to Stein’s law? In this column we analyse two metrics that investors can keep track of to judge the market situation.

Buffet Indicator

In an interview in 2001, legendary investor Warren Buffet noted that the single best measure of where valuations stand at any moment was the ratio of market capitalisation of all listed securities as a percentage of GNP. This has subsequently become famous as the Buffet Indicator. Since in many cases there is no significant difference between GNP and GDP, the market capitalisation by GDP is more commonly used.

According to Buffet, in the context of US economy, if the percentage relationship falls to the 70-80 per cent levels it’s good time to buy. If the ratio approaches 200 per cent as it did in 1999-2000 during the dotcom bubble, investors were ‘playing with fire’.

Of course, it was playing with fire as those who remained invested in the benchmark Nasdaq index at those levels of market cap-to-GDP, saw 77 per cent of their investment value burnt from the peak of the bubble in March 2000 to its bottom in October 2002.

Right now the market capitalisation-to-GDP in the US is around 190 per cent -- right in the ‘playing with fire’ zone. Given that financial events in the US always impact the rest of the world, this poses risk for stock markets across the world. .

Where does India fare in this metric? India’s current market cap-to-GDP is around 100 per cent now. While this might appear lower than the ratio in US, we need to see this in the context of our economy and history.

Our market cap-to-GDP peaked at around 149 per cent in December 2007, and the Nifty 50 index fell 60 per cent from those levels by March 2009, falling back to a ratio of a little above 60 per cent of the annual GDP at that time. Since then, the highest we have reached is 105 times in 2017 Given our history, the Buffet Indicator for India is signalling over valuation. Every time it has crossed the 80 to 90 per cent levels, markets have either crashed or atleast underperfomed risk free options. While it might be lower than the ratio in the US, one needs to factor in that we have an unorganised sector that makes up 50 per cent of the GDP and our corporate profits to GDP ratio is about half the levels prevailing in the US.

Trailing PE ratio

Historically, Indian markets have always cracked or underperfomed sooner or later after benchmark Nifty50 index nears/crosses trailing PE of around 24 times. In the peak of the Y2K/dotcom bubble, it traded up to a PE of 29 times in February 2000. From the peak level of 1,756 then, the Nifty 50 corrected by around 50 per cent as the bubble burst and unwound.

In the housing bubble driven bull market of 2007-08, it traded up to a PE of 24 times in January 2008 and subsequently the index witnessed wealth destruction of around 60 per cent as the entire world faced consequences of the sub-prime crisis created by the housing bubble. Currently, the trailing PE of Nifty 50 is at a historical high and mind boggling 36 times. Even if one were to be very generous and take an EPS 20 per cent higher (closer to FY20 consensus EPS estimates prior to covid-disruption) to adjust for Covid impact on earnings, it trades at around 29 times – levels from which it crashed in 2000.

While in general the logic is that markets look to the future and one should look at forward PE, trailing PE has been historically a good indicator from an index level. The reasons being forward earnings is built more on expectations which may or may not pan out, and the other reason being forward earnings cannot be disconnected from trailing earnings. While there might be individual cases of earnings differing vastly from trailing levels, at an aggregate or index level it is usually not the case.

Historically, trading at over stretched PE ratios has had severe consequences. For example, the main index in China SSE Composite traded up to a PE of over 40 times in 2007 as equity mania rose to historic proportions there. This culminated in a correction of more than 70 per cent. Despite robust economic growth since then, the index is still 40 per cent below its peak of 2007, nearly 14 years later. It trades at humbling PE of around 18 times today.

What this means to you

While market pundits and fund managers you watch on TV might justify these valuations by pointing to record low interest rates, they are sharing only half the truth.

The other part which is not explicitly explained is that interest rates are low because economic growth is low. Low growth will result in low earnings growth. In the long term stock markets have always been a function of earnings growth and interest rates. They are likely to perform worst when interest rates are high and earnings growth is low. They perform best when interest rates are low and earnings growth is high. Hence the current scenario where interest rates and earnings growth are low is not a case for all time high valuations.

Whether it is the Buffet Indicator or the PE ratio, the indications clearly are that Indian markets are in over-heated territory. That means it is time for you to be prudent in your equity allocation, plan for the long-term and not follow the herd for quick profits. As the famous quote from ‘The Dark Knight’ goes - ‘You either die a hero or live long enough to become the villain’. Bull markets usually choose the latter. One must invest wisely to not get trapped by the villain.