Is the Indian Equity Market Still Overvalued?

December 3, 2015
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Whether the Indian equity market is undervalued or overvalued obviously depends upon the criteria being used. I’ve seen market pundits use a variety of ratios and metrics to justify their positions. Despite the protestations of various “market wizards,” there is no holy grail of valuation. I personally use a variety of valuation indicators to assess both the market and individual equities. However, there are certain metrics and ratios that have proven over time to be highly accurate in forecasting future returns. One of these measures, the CAPE (Cyclically Adjusted Price-to-Earnings) ratio has a strong relationship to subsequent 10-year returns. The validity of the CAPE ratio has not only been proven in the US but also across international markets.

The CAPE ratio was popularized by Robert Shiller. In his book Irrational Exuberance, Shiller was able to accurately forecast the collapse of the tech bubble using the CAPE ratio along with several other valuation metrics. Although Shiller is now the most famous supporter of the CAPE ratio, the rationale for using cyclically adjusted earnings was originally provided by Graham and Dodd in their investment classic Security Analysis. The humble P/E ratio is probably the most widely used measure of value for individual stocks and the overall market. Despite its simplicity, it does have a major weakness as a valuation tool. The problem is that earnings can fluctuate widely over the course of a business cycle. For instance at the height of a boom stocks can look relatively cheap due to inflated earnings and relatively expensive at the depths of a recession when earnings are depressed. One way around this flaw is to calculate P/E using a multi-year moving average of past earnings to even out the vagaries of the business cycle.

Why should you use cyclically adjusted price-to-earnings?

Jeremy Grantham, a co-founder and Chief Investment Strategist of GMO, believes the following: “Profit margins are probably the most mean-reverting series in finance, and if profit margins do not mean-revert, then something has gone badly wrong with capitalism. If high profits do not attract competition, there is something wrong with the system and it is not functioning properly.” I would make the argument that valuation measures are the second most mean-reverting series in finance. It doesn’t matter if you use Tobin’s Q, Shiller P/E or run of the mill P/S as a valuation measure. Over a long enough cycle, each valuation measure will mean revert. The biggest crashes we’ve seen in global markets occur when both profits and valuations mean revert together. The prime example is the late 90’s tech bubble. Analysts forecasted endless earnings growth and investors placed insanely high valuation multiples on those forecasted earnings. The end result was catastrophic for shareholders over the following decade. By using cyclically adjusted earnings, you smooth out the peaks and troughs of the business cycle. Furthermore, by taking into account that a valuation measure such as P/E will eventually mean revert you are at a minimum aware whether the market is egregiously over or undervalued. I’ll be the first one to admit that the cyclically adjusted P/E is a poor short-term indicator of market movements. However, as a long-term investor it’s immensely helpful to understand the market environment that you’re facing in order to adjust your investment strategy accordingly.

Is the Indian equity market overvalued based on cyclically adjusted price-to-earnings?

The chart below courtesy of Research Affiliates compares the cyclically adjusted P/E of the BRIC economies as of September 30, 2015. With Goldman Sachs recently closing down its BRIC fund many financial pundits are making the claim that the BRIC era is now officially over. I agree that these markets are quite diverse and at different stages in their development; however, they still represent the largest emerging economies globally. In my opinion, the closing of the BRIC fund was largely a marketing decision by Goldman Sachs asset management. It’s hard to market an emerging markets fund in a potentially rising rate environment courtesy of the US Fed. Compound the problem with poor absolute fund performance and your marketing becomes a Sisyphean effort. If you’ve got a contrarian/value streak, now is the exact time you want to be looking at these markets with a 10-year time frame. The chart below highlights how cheap all the BRIC markets have become. India is currently the most expensive. Fortunately, the Indian market is still trading at a cyclically adjusted P/E of 18x which is well below its peak of 49x and median of 22x. I’ll note that doesn’t mean the market can’t trade lower in the short-term. However, buying a cheap market based on cyclically adjusted P/E will generally result in excellent long-term returns. Despite the Modi rally of 2014, the Indian market is still priced attractively at current levels.

Written by Ankur Shah

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