This is a Guest Post by Anoop Vijaykumar.
Whether you are a fundamental or technical investor, your portfolio has probably done fairly well (‘Happy New Year 2018‘) in the last 12-18 months. With P/Es of almost all indices at or near lifetime highs, it’s worth looking back to see what they might mean for near and long-term returns.
Here’s how the NIFTY and the broader NSE500 have moved over time along with their Price-Earnings. Index levels have been plotted on a log scale to highlight relative (percentage) changes rather than absolute levels since that’s what decides returns.
These charts help see how dramatic the run-up in the NIFTY was from Sep 2001 (mid 800s) to Feb 2008 (over 5,000), a 6X return over 6 years. The broader NSE 500 had an even more phenomenal run rising over 9X during that period, from 550 to 5,300.
Compared to pre-2008, the bull run since Nov 2008 has been sedate, just 4.2X (NIFTY) and 4.8X (NSE500) return over a longer time nine-year time-frame. So why are so many investors uneasy? Why the references to this global run in equities as “the most hated bull market ever“?
Consider this chart tracking growth in NSE500 Index and Earnings, rebasing both to 100 from inception till date.
Sometime in 2013, the index started rising even as earnings stayed flat or even declined. Allowing for the fact that Earnings are what happened in the past, while Prices reflect expectations from the future, it might appear those expectations at this point might be unrealistically steep, which explain P/E’s at or near all-time highs.
What does the past tell us about potential future returns?
Consider the sharp variation in Price-Earnings of both indices ranging between 10x and nearly 30x annual earnings for the NIFTY and 9x and 37x for the NSE 500. Also, note how peaks in the Price-Earnings line coincide with the index i.e. high P/Es seem to be followed by corrections and low P/Es followed by sustained increases.
How to read the chart: Blue bars on the chart show the number of days from Jan 1999 to Jan 2018 that the NIFTY closed in each P/E valuation band i.e. reading from the left to right, out of 4,729 trading days of data, on only nine days the NIFTY closed at a P/E of between 10 and 11, 49 days between 11 and 12, 160 days between 12 and 13, and so on. The orange line shows the percentage of total days that the NIFTY closed below that P/E value.
As of 8th Jan 2018, the NIFTY P/E ticked over above 27, a threshold that has been breached only 35 times in 19 years.
The NSE 500 is in even more rarified territory. The NSE 500 P/E while being more volatile, has breached 33X only 19 times in nearly 19 years.
Heady stuff indeed. What does this mean for returns?
Average returns for both indices when starting at current P/Es are abysmal, not just in the short term, but even five years out. But averages by definition are tricky. What if we looked at the best returns grouped by starting P/E?
Returns only improve marginally for high starting P/E’s. But remember, indices tend to spend very little time in these ranges either because earnings improve thus increasing the denominator in the P/E or the less popular reason, indices correct to return to more comfortable levels, or a combination of both.
Predicting market directions is futile, but history suggests some corrections might be around the corner. Invest wisely.