The Sensex is trading at 20.1k. That is 20.4X CY earnings estimates, 24.5X PY earnings estimates and 18X FY earnings estimates. Decade median levels come in at 16.5X, 20.2X and 15X respectively. The 85th percentile (the multiples at which market has traded 15% of the time) come in at 20.5X, 21.5X and 19.6X respectively. Based on this, the market is certainly expensive.
Now change the view from a year to an economic cycle. The market is trading at a PE6 multiple of 26.1X CY 6 year median earnings estimates, 28.3X PY 6 year median earnings estimates and 25.2X FY 6 year median earnings estimates. This compares with 21.2X, 21.5X and 20.3X. Even on this standard the market is expensive. Note for new readers, the PE6 is a measure derived by dividing the annual average price of the index and by the median EPS over 6 years; this measure smoothes out earnings over an economic cycle and is of interest to long term investors, though it is also useful to shorter horizon investors particularly during recessions.
Relative to SP500, the relative PE and relative PE6 are 1.4 and 1.75 compared with median decade relative PE and relative PE 6 of 0.92 and 1.6 respectively. Even by this standard, markets remain expensive relative to US markets.
The only metric I can find which indicates upside to 22.6K on Sensex is if you look at PY PE 6 2006 onwards; i.e. it covers earnings data FY2001 onwards, and market levels 2006 onwards. This indicator is useful because it highlights what investors have been willing to pay for growth over the immediately prior economic cycle. However, given the speculative excesses of our recent past, it can be misleading at the present time. Besides, one of the best indicators of an over-valued market is a hunt to find reasons for further upside.
The question of why the market is expensive is a more difficult one to answer. We have QE2; not at all a reliable basis on which to base investment decisions. We have confidence in growth; this is a good reason to invest – the markets at 20,125 with optimistic FY12 earnings estimates of Rs 1,250 is 16.1X; it's not a good enough reason for me – if the market is at 20,125 in a year, it will be reasonably valued due to earnings growth, but I will have made no money. To make money, I have to believe with conviction that FY13 earnings expectations will be strong and thus keep the markets trading at premiums to historic multiples.
Speculative excess can also drive markets; I feel this is the case but will leave you to judge whether that is the case. Today the AA bond yields 0.9% over the 10 year government note; the AAA bond yields 0.5% over the 10 year government note; the AA bond yields 0.4% over the AAA bond. Historic spreads are 1.8%, 1.1% and 0.7% - this shrinkage in spreads is a great indicator of the absence of risk aversion amongst the investor community and it is worrying.
What is interesting is that these speculative excesses are directed towards commodities and emerging markets. Within developed markets traditional PE multiples and PE6 multiples trade at below decade median levels. Spreads between 10 year treasuries and AAA and BAA bonds remain wide compared to historic averages; even the AAA versus BAA spread is wide compared to historic averages. Risk aversion has not gone away; it's there; it's strong and what little risk is being taken is directed towards emerging markets and commodities thus creating the risk of a bubble. The bubble if it truly inflates will likely only occur once risk aversion recedes in developing markets too. While liquidity in commodities and emerging markets is strong, it is a mere drop in the ocean in the context of global liquidity available.
The market is dangerous. Performance chasing and liquidity has driven markets up. Retail has to an extent been sucked in now. Complacency is high.
With knowledge of the impending Coal India IPO, strength in the Rs was reasonably foreseeable. The expectation of currency gains in addition to index driven gains was predictable by smart money. The institutional investors have made gains through liquidity induced gains in the index; they have also made gains through Rs appreciation. From activity in the derivatives markets, it would appear that much of the index driven gains have been booked. Weakening in the Rs post IPO is also a reasonable expectation and so this is a good time for institutional investors to exit with forex gains. If this occurs, weakness will spread through the delivery markets too.
For individual investors, this is a good time to return to equal weight on equity allocations; if the market continues to rise, you participate; if it falls you get an opportunity to enter high beta sectors at better valuations. In my view, the Rs should hold value or strengthen due to money flows for the Coal India IPO. This provides institutional investors a good opportunity to booking profits to exit while the Rs is strong. Post IPO you should see reduced liquidity and a pull back in market levels. A reversion to median multiples would take the Sensex to 16.7K; because we are now close to starting FY12 with good earnings growth visibility, it's unlikely a cut so deep would occur. A level of 18,600 (17,500 for a more greedy return seeker) is good to start buying, with a view to reaching target allocation to equity if the market falls to 16.7K. Watch the Rs in conjunction with the index, a return to Rs 47 /Rs 48 levels would likely indicate a good time to buy.
