NIFTY PE Chart

How expensive is the Indian equity market?

Only liars manage always to be out of the market during bad times and in during good times.” -Burton Malkiel

This simply means that timing the market is almost impossible to do on consistent basis. So, here we are not talking about timing the market but on asset allocation. Any one who was panicking last year in November may not be in a situation to reduce equity allocation as his/her equity allocation is already quite low.

In last few months, we have seen continues flow of domestic money into equity markets. The monthly systematic investment flow into mutual funds has steadily grown and inflows have become larger (Equity mutual fund inflows at record Rs 20,000 crore in August). Despite outflows from foreign institutional investors, flows have kept market surprisingly stable, raising concerns about irrational exuberance. In this article, we discuss valuation of stocks and what it means for future returns.

 There is little doubt that valuation is certainly expensive. The table below shows that the NIFTY trailing P/E ratio is almost 2std deviation above long-term average. P/B ratio as well as dividend yield look significantly more expensive than average valuation.

NIFTY Valuation data
NIFTY Valuation data, source NSE

How common is such valuation level? Based on data since Jan 1999, the current valuation level (based on trailing NIFTY P/E ratio), the current valuation level is indeed expensive and has been seen less than 5% of the time.

NIFTY PE Chart
NIFTY PE Chart, source NSE

 

Distribution of NIFTY P/E Ratio
NIFTY valuation based on PE Ratio is expensive, source NSE

 Any metric that suggests valuations are not that rich? In a recent roundtable organized by Mint, Prashant Jain of HDFC Mutual fund talked about low market cap/GDP ratio for stock market (see here). He also talked about equities are relatively cheap given the low bond yield. Essentially, if the bond yield is too low, excess return equities offer is not as low as the P/E ratio might suggest.

What does this mean for the stock market future returns? No one knows what the market is going to do tomorrow but higher valuation does mean lower return going forward. Historically, the return in subsequent 12 month has been negative from current valuation level. However, one could argue that the current earnings of Indian stock is somewhat depressed due to the impact of demonetization and GST. In next few months, market can remain resilient if earnings were to improve. However, one must temper his return expectations.

What return to expect from current P/E ratio
How has NIFTY done in past from such P/E ratios? source NSE

What to do then? Simply, in my view, a more conservative asset allocation is needed:

  • Continue SIPs/STPs as timing the market is quite difficult.
  • However, equity allocation should be reduced by booking some long-term capital gains from equity mutual fund. If the market were to correct, this money can be redeployed.
  • Be more conservative with mid-cap funds and invest more in conservative balanced funds.
  • If one is 100% in equity, then he/she is already sitting at good profit (assuming not entered the market in alst 3-4 months). They can shift completely to balanced funds, subject to some tax considerations.

 What asset allocation is rational?

 

Disclaimer: The above content is just for information and should not be construed as an offer to buy or sell or recommendation. Contact your financial advisor for guidance on any investment related query.

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