Weak signals on the Street

MARKET INSIGHT: Expect a substantial downside at current levels, no matter what indicator you rely on.

Sensitivity versus reliability: Any trader has to make a call about these two qualities whatever indicators he uses. A sensitive indicator delivers more signals; it misses fewer moves. But it also delivers more false signals. A more stable indicator delivers fewer signals and misses more market moves. But it is more reliable. The signals it does deliver will be stronger.

The usual methods involve smoothening out signals through different time-frames. For example, standard traders' systems involve short-term moving averages smoothed with a long-term moving average. You don't trade the sensitive short-term MA until it's confirmed by the more stable long-term MA. 

WHAT THE NUMBERS FORETELL
DATE	NIFTY	ASSOCIATED PE	ASSOCIATED PB	LEVEL
Jan-99	900	12.50	2.10	Low
Feb-00	1818	27.49	4.98	High
Sep-01	850	12.30	1.92	Low
Jan-04	2015	21.44	4.18	High
May-04	1292	14.41	3.09	Low
May-06	3775	21.28	5.68	High
Jun-06	2596	14.92	3.79	Low
Feb-07	4245	20.32	5.38	High
Mar-07	3555	17.44	4.62	Current

An interesting variation may be created using two fundamental ratios with different sensitivity. We can compare the price-earnings ratio of a given stock or market index with its own price to book-value ratio.

PEs are relatively sensitive -EPS can change by a massive amount annually. Therefore the denominator of the PE ratio varies a lot. PBV is less sensitive. The denominator BV changes by much less than EPS. Retained earnings are added to extant BV annually and the incremental change is much less than with EPS.

Both ratios travel in the same direction since EPS and BV vary in tandem. Both these ratios are also generally mean-reverting. The market discount for a given share or an entire market usually is within a range of PE and PBV even if the price itself rises or falls indefinitely.

Given that context, we can use PBV to smoothen out signals arising from the PE. Over the long-term PBV offers more reliable entry/ exit signals. Although PBV-based signals arise much less frequently, they have low failure rates.

What are the relevant ranges for the Nifty? Between January 1999 and March 2007, the PE ranged between 10.85 and 28.5, while the price climbed from lows of about 850 to highs of 4250. In the same time, the PBV ranged between 1.92 to highs of over 5.68.

The low-high price range translates into a CAGR of some 25.6 per cent - a truly amazing return. The Nifty's EPS has climbed from about Rs 77 (1999-2000) to Rs 205 within seven years- that is, a CAGR of about 15 per cent EPS. The BV has climbed from Rs 430 to Rs 771 - a CAGR of about 8.6 per cent. This shows that BV is more stable and changes less drastically than EPS.

In the past fiscal, EPS has grown at 23.8 per cent and BV at 19 per cent. Currently the Nifty's PE is at 17.9 while the PBV is at 4.7. If we're looking for mean-reverting tendencies, the arithmetic mean of the PE is about 17.3 while the median is at 16.6. The corresponding arithmetic mean and median of the PBV are both about 3.5.

From the perspective of a trader, the median is probably a more useful benchmark for judging entry/ exit levels. By definition, half the values would be above the median. Hence, any entry below the median value should work in the long-term. The PE is the more sensitive and it offers earlier buy/ sell signals than the PBV.

Let's say tentatively that valuations become attractive if the Nifty is below PBV of 3.25 and PE below 16. The Nifty would then be well below its median values. At current EPS and BV levels, that implies an index of 3300 (PE) and an index of 2500 on the basis of BV. The Nifty would need to decline another 400 points to hit the upper range of this valuation band.

Suppose we factor in growth at the seven-year CAGRs? The 2007-08 EPS would then be about 234 and the implied 16 X PE means an index of about 3750.

The 2007-08 BV would then be about 838 and the 3.25 X PBV implies an index of about 2725. The PE is already giving a buy signal but the PBV is not confirming it.

The seven-year CAGR is conservative. We could tweak the model with say, a three-year CAGR. That would offer more sensitive signals. Again we run into the sensitivity versus reliability issue. In practice, I'd say that a 4XPBV (3350) versus 16X PE (3750) generates a range where you could safely invest for the long-term. There would be a downside risk but the upside would be much more significant.

Whatever tool you use however, there is very likely to be a substantial downside at current levels. And, if you want a really major market bottom, you might want to wait for a bottom in the sub-3,000 zone.