Stock market gets unattractive

History suggests both passive and active investors will struggle to make money

When markets ignore valuation, experienced investors start worrying.  India is now into one of those dizzying bull runs (so is the US). The Nifty is trading at a PE (price-earnings ratio) of 23, which is uncomfortably high. But, at least, the Nifty has travelled higher in the past. 

Other market indices are at unprecedented levels — the indices tracking small-caps, mid-caps and the ‘Junior’ are all trading at all-time highs in terms of valuations. In terms of pricelines, each of these is also near their respective all-time highs. 

It's hard to justify these valuations normally. However, there is one accounting ratio, which could justify it. High PE valuations are generally justified by forecasts of very rapid growth and also by very low and falling interest rates.  The growth logic is generally justified by comparison of earnings growth to the PE ratio by the so-called PEG (price-earnings to growth ratio). If earnings per share (EPS) is growing at X per cent and the PE ratio is Y, then the PEG is derived by dividing X/Y. If the PEG is at 1 or less, the valuations are reckoned to be justified. 

Opinions vary as to the length of the time periods, which should be used to run such calculations. Should the ratios and the growth value be smoothened out by taking an average, or a median, of several previous periods?  Should PEG include forecasts? 

Anyhow, the third quarter of 2016-17 saw net profit growing at 27-28 per cent year-on-year for a sample of over 1,600 companies. Profits grew at 17 per cent for the Nifty companies. There is a base effect because Q3, 2015-16 was the bottom of a downtrending business cycle. Profit growth has been negative, or in low single digits for much of the past two years. Nonetheless, a recovery in global metal markets and a decent agro-performance has helped in terms of profit growth. 

If we take this specific quarter (October-December 2016), the PEG would be reasonable at 1 or less, for the broad market.  If the Nifty is examined, the PEG is over-valued but not too bad at 23/17 or about 1.3. If the ratios are smoothened out by taking the past four quarters, profits drop to low single digits.   

The PEG suggests that the broad market is considerably overvalued if we look at the past four quarters. Given EPS growth at less than five per cent over the last four quarters, the PEG is at well over four.  Of course, the optimists would also suggest that the Q3, 2016-17 levels of profit growth can be maintained for the next few quarters. The underlying logic would be that the commodity cycle upturn is now sustainable and the base effect will last for quite a few more quarters. 

Another way of looking at it is to compare PE to interest rates. The Reserve Bank of India (RBI) has held rates steady for the past two policy reviews. The central bank appears to be quite worried about possible inflationary pressures going forward. However, it is unlikely to raise rates since the Consumer Price Index is at a multi-year-low. Treasury yields are at around seven per cent. That would be roughly equivalent to a PE of about 14-15. By this measure, the market is about 50 per cent overvalued. 

Other valuation measures also suggest that the market is being optimistic. The price-book value ratios for the Nifty are over 3.4, which is historically high.  Another way of looking at it, is to assess what returns have been in historical terms for similar valuations.  

In historical terms, investments made at these levels have usually not started paying off until five years or longer. The website, Capitalmind, claims the averaged returns for Nifty investments made at a PE of 23 have been negative for up to three years.  The five-year returns are positive but even so, at an averaged 5-year return of 6.94 per cent, the long-term investor would be unwilling to buy equity. Debt will produce that sort of return or better with far less risk involved. 

This sort of situation presents a huge problem. The passive investor has to just forget about returns for several years while the active value investor will struggle to locate stocks trading at anywhere near attractive levels. The historical statistics suggest that the odds are against generating decent returns. Sustained growth acceleration would be required to pull valuations down to reasonable levels.