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It’s interesting to see how P/E ranges impact longer term returns. If you look at a Price to Earnings Ratio (P/E) independent of anything else, it’s not very useful – because the earnings growth might actually be spectacularly high, or expected to be.

The Nifty is now at a P/E of 23. This is high, but still below highs of 2015/16 where we saw it beyond 24. If, in the past, you had held the Nifty when it was at a P/E of 23, then you would see:

• Average 1 year returns of -10%

• Average 3 year returns of -1.89% (annualized)

• Average 5 year returns of 6.94% (annualized)

• Average 7 year returns of 12.12% (annualized)

• Average 10 year returns of 13.44% (annualized)

The longer term returns have little data though, since we only have P/E data sine 1999, so it’s really been one earnings cycle.

Earnings growth as a whole is up about 2.6% but the cycle seems to be turning. If we look at Q3 alone, the Nifty companies saw a 17% increase in aggregate profit! (Mostly due to a low base and the oil companies turning a profit, but still)

The market’s a little hot and it’s not exactly the best time to sell your neighbour’s house and invest. But let’s look at other and broader indexes.

The Junior: Better performer, but still too hot

While the top 50 companies may be boring, the next 50 are not. They’ve moved up a lot and the Junior is actually at an all time high. Yet, with a P/E of 24, returns don’t look THAT exciting.

What works in Junior’s favour is that earnings growth has bumped up to 13% which narrows the valuation gap.

The Broader 500: Earnings Growth Subdued

Earnings for the Nifty 500 have only grown 1%. This is better than earlier but 1% isn’t something to be proud of.

The P/E is at 26. Historical averages show that life doesn’t get much better for a three year return.

Midcaps:  Uncharted Territory on P/E

The Nifty Midcap 100 index has a P/E of 30. This is very high, and really, is uncharted territory since the Midcap 100 P/E has not been higher than 28 other than in the last year or so.

This index is relatively new but there is some data in the past, of the index P/E being overvalued at 26. Earnings growth at a negative 2% doesn’t help in the valuation.

Our View: Indexes are Hot, Not Euphoric Yet, Returns Unfavourable

To bring P/E down, you can either have a price correction or earnings can grow up. Earnings have been subdued for nearly all indexes in the last two years. And the P/E is relatively not as high as it used to be. However, prices might still not increase dramatically even if earnings go up, and from a long term perspective, that remains a key risk – that the price upside is somewhat limited in the 1 to 3 year term.

While this is not actionable, it is a factor to consider when you allocate money to stocks. At this time it seems to us that the optimal allocation would a 65-35 allocation to stocks:debt. (Or, hedge to bring down exposure to equity to that extent).

Now, tell them about it: