Humans have always been amazed by the equity markets. There few better thrills than seeing the index/stock value gyrate up or down in your favor.
It is this thrill or adrenaline rush of watching the Nifty/Sensex that addicts people initially to the stock market. Easy money or Easy loss is a part of the market. But is there any relationship between Index PE and returns made by investors.
If market goes up and down every day, then can’t we buy low and sell high or vice versa. Let me be very frank. If you’re looking for quick returns then the stock market is not the place to be in.
You can make intelligent returns but equity market is not a ‘get rich quick’ scheme. You can check this post for how to make long term investments in stocks.
Yes, it is possible to trade and make money but you’ve be well informed and have discipline to earn from trading. This post does not add much value to seasoned investors who’re very stock specific but useful mainly for novice investors who invest in large caps.
Relationship between Index Price Earnings and Returns
It is wise to invest in the oversold market rather than an overvalued market. I have found that there is a direct relationship between an index PE (for e.g. Nifty index PE) and returns for long term investors though not a linear one.
Investments made when the market is oversold fetches higher returns than investments made during an overvalued market.But it is very difficult to get the exact bottom or top of the short term market.
Overvalued (also called overbought) markets are times when the valuations or prices of stock are very high or high. Oversold markets are times when valuations or prices of stocks are low or very low.
So, when one invests during an overvalued market one does not get an opportunity for greater growth in share prices. Hence the returns tend to be lower.
At the same time when right investments are made when the markets are oversold there is a huge opportunity for an upward movement in the stock and hence the investor can make superior returns.
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When does one know whether a market is in a overvalued or oversold position? A reliable indicator is the PE of an index like Nifty. Nifty is an index of 50 shares on the National Stock Exchange (NSE). Nifty Index PE generally moves in the 5 to 25 range, where 5 is the lower level or the oversold position and 25 indicates an overvalued or overbought position.
(Data source for above graph: nseindia.com)
The chart above indicates PE values of Nifty Index over the last 16 years beginning in 1999 and up to 2015. It can be seen that there are several peaks (high positions) and troughs (low positions) during the course of this period.
When Nifty index commenced it started growing rapidly during the turn of the millennium, the Nifty Index PE value grew from a low of around 12 at the start of 1999 and rose up to a high of above 27 during the end of February 2000. This was when the Internet boom was at its peak and so was the market.
This point in the Indian stock market history can certainly be regarded as a period marked by an overvalued or overbought market position.
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Investments made during this time would not have much scope for further growth or superior returns. In fact, there is even a danger of negative returns. There are several such peak positions that can be seen in the above chart. These could be possible opportunities for part or full profit booking.
There are several troughs or low positions also that are clearly visible in the above chart. These are opportunities, for making fresh investments in stocks, or to add to the existing ones. One may not be able to predict the exact highest or lowest points. However, one can surely make a commonsense judgement as to whether a market is overbought or oversold.
One can make fresh investments when Nifty PE is in the 10 to 15 ranges. Similarly, the range in between 20 to 25 may be the right time to sell partially or completely or as desired.
One might think what difference does it make if one does not pay attention to lets say the Nifty index PE value. However, it does make a substantial difference to the returns earned, if the index PE is tracked, and utilized to make an investment decision especially for those who invest in large caps.
Various research and studies conducted by several experts suggests that investments done when the index PE is in low range of 10 to 15 is likely to earn a much higher return than investments made when index PE is in 20 to 25 range.
The above chart depicts the Nifty index along with the PE of Nifty Index. The Nifty index depicted by the green line in the graph starts below 1000 points in 1999 and goes all the way beyond 8000 levels in 2015.
The blue line is the same PE line shown in the earlier graph. Superimposing the Nifty index line on the Nifty index PE line gives us more useful insights about the relationship between the Nifty index PE line and returns.
One simple observation you can make is that while the Nifty index shows an upward trend over the 16 year period from left to right of the graph, the Nifty index PE is rather range-bound.
As suggested above the range is roughly in between 5 to 30. So, this means that whatever level the index reaches, the index PE would indicate the right time or at least a favourable time for entry/ exit to the investors. One may argue that one cannot really time the market, but there is enough data to suggest the positive effects of using index PE to ones advantage to earn higher returns.
However, Index PE, rather than a be used as a tool to time the market, should be used as a good risk-measuring tool.
If one knows, in what sort of market one is in, meaning, in an overvalued or an undervalued market, one can position one’s investment portfolio accordingly. If one finds that the market is overvalued then it would be better to hedge one’s position or stay away. On the other hand if one finds that the market is undervalued then it would be better to buy aggressively.
So, did you find this useful ? Do you agree with the usage of Index PE to reduce risk or you believe there is no relationship between Index PE and returns? Let me know your opinion.