January 2, 2013
The Sensex and Nifty ended 2012 up 25.2% and 27.4%, respectively. The downside to this strong price performance is that the Indian stock market is now the world’s most expensive based on a cyclically adjusted price-earnings ratio (CAPE) or the Shiller P/E as it’s more commonly known. The CAPE is an excellent tool for forecasting future stock returns over long periods of time, such as a decade. The CAPE is calculated the way a normal P/E ratio is calculated but the denominator is an average of the past 10 years of earnings as opposed to a single year’s earnings for a particular index or stock. By taking an average over the past 10 years, you smooth out the volatility in profitability that occurs due to the business cycle. Earnings in general tend to be mean reverting thus the traditional P/E ratio is artificially low at the peak and artificially high at the trough of the business cycle.
Based on the chart below, courtesy of Business Insider, we can see that the Indian stock market currently has a CAPE of 25x. More importantly, the Indian stock market is now overvalued relative to both emerging and developed markets around the world. It’s highly unlikely that FII’s will continue pouring money into the domestic Indian market at such astronomic valuation levels.
Additionally, you might be wondering to yourself markets can stay overvalued for a long time so what’s the big deal about a high CAPE ratio?
You would be correct in your assumption since CAPE doesn’t really help you identify where the market will head in the next 6 months or even next year. However, if you have an investing timeframe that expands beyond that of your typical daytrader and are interested in the long-term compounding of your capital then you should pay attention to the CAPE ratio.
The table below was created by Clifford Asness, a super quant, who runs a multi-billion dollar hedge fund called AQR Capital. You can access the full paper here. We can see from the table that 10 year average real returns for the S&P 500 over a ten year period when the CAPE at the beginning of the period was 25x or higher was 0.5%. The worst case outcome is even more unappealing at -6.1%. The moral of this story is that valuation matters, whether we are talking about individual stocks or an index as a whole.
I agree that this data only applies to the US market. However, there have been numerous studies showing that the CAPE ratio has predictive capabilities even in emerging markets, including India. The bottom line is that as an investor you need to be cognizant about valuation levels. The Indian market is not cheap and long-term returns from such lofty valuation levels will most likely end up being disappointing. Don’t be persuaded by analysts who try to dazzle and amaze you with how cheap the market looks on a forward operating earnings basis. Those same analysts will also dazzle and amaze you with the rapidity of their earnings downgrades when the global business cycle turns downward again. The key to investing in the current market is to focus on companies with sustainable competitive advantages, strong FCF generation and of course trading at reasonable valuation levels.