From here, you could get 22 per cent returns if the Nifty reverts to 6300 plus levels.
There’s a “pivot point” in any ongoing bear market. Above the pivot, the risk (potential downside) exceeds the reward (potential upside). Below that, the reward exceeds the risk. In this instance, I think the pivot is somewhere between Nifty 4500-4800.
Before we get into explanations, let’s define time-frames. In what follows, the assumption is that the investor can hold for a couple of years or longer. Whatever you commit to equities in such a situation should be committed gradually and systematically. Average down in order to take advantage of further drops.
This downtrend could continue for an indeterminate and prolonged period and prices could fall substantially. The two don’t necessarily go together. There can be long periods of drift. But it’s safer to assume both a prolonged downtrend, as well as a big downside.
In valuations terms, the market is very close to long-term average levels, after a pullback from the November 2010 highs to a new 52-week low. The Nifty’s PE is now at 18.7, down from 25-plus in November. This is the same as the 10-year average PE. The dividend yield is 1.3 per cent.
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In historical terms, these valuations are neutral. The Nifty is always an excellent long-term buy below 15PE (roughly the long-term average minus one standard deviation) and at dividend yields of above 1.5 per cent. At 18.7, with a yield of 1.3 per cent, it’s a so-so buy.
Once you adjust earnings projections for inflation expectations, it’s difficult to justify PEs of 18-plus in terms of PEG. Given current events in the US, in Europe and in Japan, it’s odds-on that Q2 will end with further earnings downgrades. EPS growth in 2011-12 over 2010-11 will probably be less than 10 per cent, after inflation-adjustment.
The Nifty starts looking attractive only in terms of historical valuations if the market falls another 10-15 per cent (till 4600-4800) in the next 2 months. Alternatively, it could stay close to 5200 for the next two quarters while earnings grow. In either of these scenarios, the discount drop to 15PE.
Now let’s make some guesses as to potential upside and downsides. The next bull market, as and when, will by definition, see the Nifty push to 6300-plus. It may rise a lot higher of course. But a minimum target of 6300-plus will be achieved. Given Indian time cycles, this is likely to occur by the second half of 2013-14. That is 24-odd months. Before the next bull market starts, the downside could be considerable. The last two bear markets saw retractions of greater than 50 per cent from the highs. If history repeats, we could see values in the range of 3200 before this bear market ends.
But as mentioned above, below 4800, valuations look attractive. The 4800 level is also the Fibonacci retraction level of 38.2 per cent for the last bull market. There, the index rose from a low of 2250 (October 2008) to a high of 6330 (November 2010). The 50 per cent retraction level would be around 4200. Take the difference (4200-4800) and assume a downside of 4500 would be likely.
Try some risk:reward estimates. At current levels of 5200, you have a fair chance of getting 1100-plus (20-22 per cent) returns as and when the Nifty reverts to 6300-plus. You also have a potential downside of around 700-1000 points - that’s a loss of 15-20 per cent. So the risk: reward equation is slightly in favour of investing at current levels if we neglect time. Considering the time factor, that 20 per cent upside could take over two years to fructify. A fixed deposit would fetch similar returns with zero capital risk.
At Nifty 4800, the investor would have a potential upside of roughly 30 per cent, and a downside of 6-10 per cent, assuming bottoms between 4200-4500. Even taking time into consideration, this is much more attractive. At every level below 4800, the risk:reward equation for equity investments becomes more and more attractive vis a vis fixed income.
The estimates given above are deliberately fuzzy. It would be easy to work out things to the third decimal, given the underlying assumptions. However that would not make the predictions any more accurate. One has to allow for large error factors when making this sort of long-term projection.
You may agree or disagree with the above logic or make different assumptions about the possible upside and downsides. But you need to think along these lines to answer the key question: When should you get overweight in Indian equities?