The study of financial markets could well be called the study of bubbles. Speculative bubbles have occurred across every historic era. Arguably, the biggest driver for economists is the need to identify bubbles and to learn to deal with them. Ideally, policy action should prevent bubbles occurring. If a bubble does start inflating, policy should then be designed to let it deflate with the least possible damage.
Identifying a bubble in time is a primary requirement for any sort of mitigating action to work. There is no absolutely iron-clad way to identify a bubble. The analyst may have to look for unusual price action and inflated valuations across multiple markets.
There are two long-term valuation tools, which appear to identify bubbles with some degree of reliability. One is the Q ratio invented by James Tobin. In Q, the market value of an asset is divided by its replacement cost. This is often represented by the market price of a share divided by the book value (BV), the price/BV ratio which is roughly the same as Q. (If there is very high inflation or steep deflation, Q will differ significantly from BV since the BV is calculated with long gaps).
Q should be a mean-reverting ratio over time. Indeed, it tends to have values that trade within a given range. Bubbles tend to arise when the current value of Q is two standard deviations or more higher than the long-term average of Q for a given market.
A second valuation tool that helps to identify bubbles is Robert Shiller's version of the price-earnings (PE) ratio. Here the long-term earnings (usually over the past 10 years) are adjusted for inflation across that period. (Usually, each year's earnings are indexed to that year's inflation and then the average of the 10 adjusted earnings is taken).
The current price is then divided by the adjusted earnings to derive Shiller's PE ratio. This ratio is also mean-reverting and less volatile than the unadjusted PE or earnings. If the current value is above the average plus two standard deviations, valuations are reckoned to be in bubble territory.
As of the present moment, Indian stock markets are trading at record highs. But valuations appear to be nowhere near bubble territory. The current PBV ratio of the Nifty index is about 3.3. This is well below the 15-year average of 3.55 (median of 3.48).
Calculating a long-term inflation-adjusted PE for the Nifty is tough. Apart from the usual vagaries of stocks being replaced and weighting issues, there is a basic problem with picking an Indian inflation benchmark. The Wholesale Price Index (WPI) is available across that period, but the WPI is not necessarily a good inflation benchmark. The unified Consumer Price Index (CPI) was launched much more recently and reconciling and inflation-adjusting earlier CPI indices is a difficult task.
The unadjusted PE averages out to between 18.2 (median) to 18.4 (mean) with a standard deviation of about 3.4 using daily index data since January 2000. If we assume an inflation CAGR of 7 per cent since January 2000, the adjusted PE averages out to 19.9 and the standard deviation is 4.3. The current PE is 18.7 (unadjusted) and 19.5 (adjusted). Again, this is nowhere near bubble territory.
Admittedly, earnings growth has been poor in the past couple of years and the valuations would seem high on the basis of current earnings growth rates. Nor are there expectations of a great acceleration in 2014-15 growth rates. On those grounds, there's room for decline. But the long-term averages also indicate that there is ample room for an upside.
The Nifty could swing by 15 per cent in either direction without moving even one standard deviation away from the long-term mean and the trader should be prepared for this. The chances for an upside would obviously be enhanced if macroeconomic fundamentals improve. Ideally, any investor would want to see a reduction in inflation and acceleration in the GDP growth rate. The chances for downsides would increase if the political scenario does not promise stability.
Identifying a bubble in time is a primary requirement for any sort of mitigating action to work. There is no absolutely iron-clad way to identify a bubble. The analyst may have to look for unusual price action and inflated valuations across multiple markets.
There are two long-term valuation tools, which appear to identify bubbles with some degree of reliability. One is the Q ratio invented by James Tobin. In Q, the market value of an asset is divided by its replacement cost. This is often represented by the market price of a share divided by the book value (BV), the price/BV ratio which is roughly the same as Q. (If there is very high inflation or steep deflation, Q will differ significantly from BV since the BV is calculated with long gaps).
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If Q is greater than 1, the market value of a business is, for whatever reason, higher than the replacement cost of the same business. It should, therefore, be possible to build greenfield assets cheap. Under such circumstances, new investments should flow into the primary market and new capacity should be built. If Q is less than 1, the asset is under-valued. There is then less incentive to invest in new assets, but the secondary market should see investment interest involved in bidding up existing assets.
Q should be a mean-reverting ratio over time. Indeed, it tends to have values that trade within a given range. Bubbles tend to arise when the current value of Q is two standard deviations or more higher than the long-term average of Q for a given market.
A second valuation tool that helps to identify bubbles is Robert Shiller's version of the price-earnings (PE) ratio. Here the long-term earnings (usually over the past 10 years) are adjusted for inflation across that period. (Usually, each year's earnings are indexed to that year's inflation and then the average of the 10 adjusted earnings is taken).
The current price is then divided by the adjusted earnings to derive Shiller's PE ratio. This ratio is also mean-reverting and less volatile than the unadjusted PE or earnings. If the current value is above the average plus two standard deviations, valuations are reckoned to be in bubble territory.
As of the present moment, Indian stock markets are trading at record highs. But valuations appear to be nowhere near bubble territory. The current PBV ratio of the Nifty index is about 3.3. This is well below the 15-year average of 3.55 (median of 3.48).
Calculating a long-term inflation-adjusted PE for the Nifty is tough. Apart from the usual vagaries of stocks being replaced and weighting issues, there is a basic problem with picking an Indian inflation benchmark. The Wholesale Price Index (WPI) is available across that period, but the WPI is not necessarily a good inflation benchmark. The unified Consumer Price Index (CPI) was launched much more recently and reconciling and inflation-adjusting earlier CPI indices is a difficult task.
The unadjusted PE averages out to between 18.2 (median) to 18.4 (mean) with a standard deviation of about 3.4 using daily index data since January 2000. If we assume an inflation CAGR of 7 per cent since January 2000, the adjusted PE averages out to 19.9 and the standard deviation is 4.3. The current PE is 18.7 (unadjusted) and 19.5 (adjusted). Again, this is nowhere near bubble territory.
Admittedly, earnings growth has been poor in the past couple of years and the valuations would seem high on the basis of current earnings growth rates. Nor are there expectations of a great acceleration in 2014-15 growth rates. On those grounds, there's room for decline. But the long-term averages also indicate that there is ample room for an upside.
The Nifty could swing by 15 per cent in either direction without moving even one standard deviation away from the long-term mean and the trader should be prepared for this. The chances for an upside would obviously be enhanced if macroeconomic fundamentals improve. Ideally, any investor would want to see a reduction in inflation and acceleration in the GDP growth rate. The chances for downsides would increase if the political scenario does not promise stability.