We all know of the P/E ratio and the Price/Book ratio as two very core metrics of stock market valuations. In fact, if you add dividend yield then we have the triumvirate that completes your valuation methodology. While each of these 3 metrics can also be applied to individual stocks and to sectors, it is at a macro market level that they are most relevant. For example, if you look at the overall market P/E ration or the dividend yield ratio then you will find a consistency in the way the stock markets react when the P/E ratio goes above a threshold or below a threshold. Let us look at the P/E for stock market valuations..

How the Nifty P/D ratio panned out over time..

The P/E chart below captures the P/E ratio as a monthly average over a period of 20 years. In the last 20 years, the markets saw a sharp correction in the year 2000 after the technology meltdown and again in 2008 after the Lehman disaster. On both the occasions the P/E Ratio was at an outlier above 25. In the year 2018, the P/E ratio is again close to the 25 mark. There are 2 ways to look at this data. Apart from the level of P/E ratio, you also need to look at whether the earnings cycle is at the peak or at the bottom. In 2000 and in 2008 when the Nifty corrected over 40% from their peak, Indian companies were already at the peak of their earnings cycle. Therefore, the Nifty crash coincided with the reversal of the earnings cycle. In 2018 the earnings cycle has just about begun to pick up and the GDP growth is trying to get back to normal after a 4 year lull.

Date Source: NSE

The only problem with the above chart is that it considers the P/E ratio as a monthly average and the movement in the other 12 months of any year tend to get ignored. That is why the sharp peak of December 2007 is not considered in the chart above. To get a clearer picture of the P/E ratio as a valuation metrics, let us take more granular data of P/E ratios for the last 20 years.

A more granular approach to P/E ratio data for 20 years..

The above chart clearly highlights the movement of P/E ratio over the last 20 years. The peaks of 2000 and 2008 as well as the troughs of 2003 and 2009 in valuation terms are captured very clearly in this chart. There are 4 things that emerge from the chart above.

In the last 20 years, the markets have gone above 2SD (standard deviation) and below 2 SD only twice. It had gone above 2SD in 2000 and 2008 and below 2SD in 2003 and 2009.

The two situations of above 2SD turned out to be long term tops for the market which took nearly 8 years to break out. Similarly, the 2 situations below 2SD also proved to be long term bottoms which markets have not revisited again.

Within these long term cycles, there have been series of mini bull markets and mini bear markets around the 1SD levels. This is the more normal behaviour of the market.

The P/E ratio is back to the 2SD levels on the up side in 2018 but a lot will depend on how the earnings momentum pans out in the coming quarters.

Nifty P/E ratio - Can the 1SD levels and 2SD levels be used to time markets?

That brings us to a fundamental question as to whether we can also use the Nifty P/E ratio based on the range to smartly time the market and enhance returns. Let us look at how the Nifty has performed historically if you bought the Nifty at different levels of P/E. To get a better perspective of level based returns, we look at two time frames of 3 years and also of 5 years. The idea of the 3 year perspective is to get a quick short term response while that of a 5 year return is to get a slightly longer term perspective. The idea is to test whether the whole idea of buying at lower P/E really works for you in the medium run and long run..

The above analysis of the impact of buying at different levels of P/E is quite interesting. When you consider a 3 year time frame there is a clear relationship between the level of P/E that you buy at and your returns. The advantage of buying at lower P/E is evident. However, when you consider a 5 year perspective, that low P/E advantage gradually starts to diminish. That essentially means that if you were to do a SIP on an equity fund then the level of your entry would be actually immaterial from your long term wealth creation point of view. That could be the big takeaway.

Can we also use P/BV and Dividend yield?

Like we use P/E ratio to measure overvaluation and under valuation of markets, one can also use P/BV and Dividend yield. However, the P/BV is more vulnerable to overprice companies with low book value and under-price companies with high book value. Similarly, dividend yields tend to overprice stocks with high dividend yields. Also the dividend yields of the Nifty could get structurally impacted by the tax on dividends that have been imposed at 3 levels. P/E ratio offers a good approximation of the market valuation when looked at in terms of the 1SD and 2SD.

The big news is that one need not obsess over the P/E of the Nifty if the perspective is over 5 years. In fact, the longer time frame you consider, the lower the P/E hunting is going to actually matter to your returns!

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