September 30, 2013
Graham and Dodd in their seminal book on value investing, Security Analysis, outlined the use of cyclically adjusted earnings over a 5-10 year period to smooth out the earnings cycle when calculating fundamental ratios such as P/E. The main issue when valuing either an individual stock or a broader index using a P/E ratio based on trailing twelve month earnings is that earnings in any given year can be highly cyclical. At the peak of a business cycle earnings for an index as a whole will be high resulting in a P/E ratio that is too low. Conversely during recessions earnings can rapidly decline as we saw in 2008/2009 and a P/E ratio based on trailing twelve month earnings will be too high making the market look expensive at a time when the market is near its cyclical bottom. The solution to this problem is to use a 5-10 year average for earnings, which will smooth the peaks and valleys in the earnings cycle.
Robert Shiller, who wrote Irrational Exuberance: (Second Edition), also utilized the cyclically adjusted P/E (CAPE) ratio as a valuation measure for the overall market because it determines how expensive the market is relative to an objective measure of the ability of a corporation to earn profits. Shiller actually used a ten year CAPE ratio for the S&P 500 to correctly identify the market bubble in 2000. To calculate the 10 year average cyclically adjusted P/E ratio for any market you divide the inflation adjusted price of the index on a monthly basis by an inflation adjusted 10 year average of trailing twelve month earnings.
At this point you might be wondering what exactly is the benefit of calculating the CAPE ratio of a market. Both Mebane Faber of Cambria Investments and Cliff Asness of AQR Capital have found that future 10-year average returns in the stock market are inversely correlated with the CAPE ratio. Thus, the higher the CAPE ratio at the beginning of any ten year investment period the lower your return has been historically. Valuation is important in not only selecting the right stocks but also applies to the overall level of an index.
The chart below shows the 5-year average CAPE ratio for the CNX 500. I chose to use the CNX 500 because it’s a broader index relative to either the Nifty or the Sensex and thus would give a more holistic view on market valuation. Additionally, I adjusted the level of the index and historical trailing twelve months earnings using the WPI index, which is a wholesale price index. I chose to use the WPI because it has a more complete data history relative to the CPI in India and is the measure preferred by the RBI (Reserve Bank of India) to measure inflation. I was also forced to use a 5-year average vs. a longer 10-year average because of a lack of historical data on earnings from the NSE. Despite the shorter timeframe a 5-year period is still long enough to smooth out extremities in the earnings cycle. We can see from the chart below that the P/E 5 ratio peaked out at 25.3x in December, 2007 and bottomed at 8.7x in March, 2009. Interestingly, both the CNX 500 and S&P 500 hit their cycle lows on March 9, 2009.
The good news is that the Indian market is not overvalued at current levels and is trading below the 9 year average P/E 5 ratio of 16x. The bad news is that this will tell you absolutely nothing about prospective returns over the next year. The CAPE ratio is helpful in determining returns over longer time frames. However, Mebane Faber, Ed Easterling and Rob Arnott have found empirically that investors are willing to pay higher valuation multiples when inflation is under control. We can see from the chart below that WPI inflation has been declining since 2010. If the new RBI chief can meaningfully bring down inflation further, there is a strong likelihood that valuation multiples could expand from current levels.
In my view, stock selection is going to be the key driver of returns for Indian investors going forward as the market is not either extremely over or under valued. The key will be to focus on high quality businesses that are trading at reasonable valuation levels. The RBI’s battle with inflation will continue to slow economic growth. However, over a longer time frame bringing inflation under control will result in higher valuation multiples. Thus, investors should look for any near term weakness in equities to build positions as the the upside potential could be significant under a low inflation scenario. A decrease in inflation would give the RBI enough headroom to begin lowering interest rates, which would drive earnings growth. The last time we had a combination of high earnings growth and low inflation was in 2002. I’m not saying that we’ll have a repeat of the 2002 cycle, but current valuation levels could go higher and drive equity returns if the stars align in terms of earnings growth and inflation.