Misconceptions about the Nifty PE

Are the markets overvalued? Is the Nifty PE too high? Should I exit and re-enter later? Aided by  'experts' who advice 'caution', such questions are doing the rounds again.  Here are some misconceptions and myths about the Nifty PE.

In a previous post on the relevance of the Nifty PE for the long-term investor, I had shown that exiting at high PE and re-entering at low PE does not guarantee loss-prevention or  large gains! The spread in possible returns is too high.

I wrote,  the case for not investing at high PE (~ 25) remains strong enough, whereas the case for investing only at low PE (< 15) has weakened, thanks to the wide range of returns possible.

Dumb me,  I missed the obvious corollary:

If I exit at PE = 25, when do I enter? The answer is whenever!

So one could, and must argue, why exit in the first place if your goal is several years away?

Unfortunately, neither can we rely on past data (our market history is too short), nor can we invest without emotion. So  for someone with considerable net worth, it is not a terrible idea to reduce equity exposure at 25 PE.

There is the danger that after exit the markets may create history and keep moving up  but I think it is not such a terrible issue for a mature person.

With that out of the way, let us consider what Prof. Sanjay Bakshi writes in an article titled, "Keeping you out of trouble: your resolutions for 2009 and beyond", he says

Resolution 1: You will avoid equities when they become historically expensive

Recent research done by my firm shows just how dangerous it is to remain invested in an
expensive market. Since NSE started, every time when Nifty’s Price/Earnings ratio exceeded 22, the
average return from Indian equities over the subsequent three years became negative — see
accompanying table.
Nifty’s PE        Three year returns%
Less than 14    152.10%
14 -16                112.36.%
16 - 18               79.14%
18 - 20              51.18%
20 - 22              21.18%
22 - 24            -14.98%
24 - 26            -32.92%
26 - 28            -36.60%
28 - 30            -40.17%
I am afraid averages without considering standard deviation or the spread is of little use. To imply and to assume that the return was negative when PE exceeded 22, based on this result is baseless, at least for Nifty stocks.
Rolling returns offer better insight.
nifty-pe-myth-1
 The red dots refer to the PE when 3 year returns were negative if invested on that date.

Notice most of the data is centered around the dot-com crash. PE values from about 16 to 20 led to negative returns and not just 22.

Notice the small bunch of red points right in the middle of the so-called 'bull run'. Related reading: Anatomy of a bull market

Then  we have some points just before the 2008 crash and some points in 2010 when PE was close to 25.

A negative 3 year return and a PE of 22 or above occurred only 42.7 times out of 100! The rest of the times, the negative returns came when PE was between 15 and 22! Please don't bet that a high PE implies a low return .... at least over 3Y!

Notice the spread in returns possible corresponding to the PE on the date of investment. Current PE is close to 22. So the blue box tells you what to expect or rather what not to expect.

nifty-pe-myth-2

Now to 5 year returns. There is not enough negative returns data available. All points in that bunch correspond to a PE greater than or equal to 24.5.

Meaning, if you stay invested for 5 years, current PE most likely does not matter!

nifty-pe-myth-3

 Notice that the bunch (below) has not shifted to the right. Again the spread is too large.
nifty-pe-myth-4
You can see similar graphs for longer durations here: relevance of the Nifty PE for the long-term investor
Moral of the story: If you want to exit because the PE is 'high', please do not point to market history. Point to yourself.

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48 thoughts on “Misconceptions about the Nifty PE

  1. Anonymous

    Thank you for the post, what about a new investor entering at high PE, shall he wait until the PE gets low or continue to invest at high PE itself.

    Reply
  2. Anonymous

    Thank you for the post, what about a new investor entering at high PE, shall he wait until the PE gets low or continue to invest at high PE itself.

    Reply
  3. Deep

    Interesting analysis.Personally i believe in equities wealth is made by "time in the market" and not "timing the market".Be patient,be humble in the long run u won't regret it.

    Reply
  4. Deep

    Interesting analysis.Personally i believe in equities wealth is made by "time in the market" and not "timing the market".Be patient,be humble in the long run u won't regret it.

    Reply
  5. Saurabh Mittal

    Hello Sir, this is a great info, please share the excel sheet with me. Also if possible please provide the following data. As you mentioned that at P/E of 22 on a 3 year horizon, 42.7 times Nifty gave a negative return, please provide a range of returns for the balance 57.3 times. So for eg how much times it was below 10%, between 10 -20%, between 20-30% and above 30%. I believe that you will be considering 3 year absolute return for this.

    Reply
  6. Saurabh Mittal

    Hello Sir, this is a great info, please share the excel sheet with me. Also if possible please provide the following data. As you mentioned that at P/E of 22 on a 3 year horizon, 42.7 times Nifty gave a negative return, please provide a range of returns for the balance 57.3 times. So for eg how much times it was below 10%, between 10 -20%, between 20-30% and above 30%. I believe that you will be considering 3 year absolute return for this.

    Reply
  7. Ashish Gupta

    Aren't you missing that when one exists at higher PE of 25, and can enter anywhere, even if goal is more than 5 years ahead, existing and re-entering still make senses because one can gain by keeping fund in debt instruments at say 8% for those intermediate periods? Also this analysis seems to be for lump sum investment, and I am keen to explore multiple other SI-PE linked strategies.

    Reply
    1. pattu

      No I am not missing that out. The data suggests that the spread is too large to say one way or the other. All we know is higher the duration, more comfortably placed is the bunch to the right (positive returns). Tactical calls may work or may not. It will keep the investor calmer. That is for sure. Rolling SIP calculations can be a pain. Let me see what I can do.

      Reply
  8. Ashish Gupta

    Aren't you missing that when one exists at higher PE of 25, and can enter anywhere, even if goal is more than 5 years ahead, existing and re-entering still make senses because one can gain by keeping fund in debt instruments at say 8% for those intermediate periods? Also this analysis seems to be for lump sum investment, and I am keen to explore multiple other SI-PE linked strategies.

    Reply
    1. pattu

      No I am not missing that out. The data suggests that the spread is too large to say one way or the other. All we know is higher the duration, more comfortably placed is the bunch to the right (positive returns). Tactical calls may work or may not. It will keep the investor calmer. That is for sure. Rolling SIP calculations can be a pain. Let me see what I can do.

      Reply
  9. Prashanth

    Hello Pattu sir, this is prashanth. I have a query …. I am actually new to mutual funds, i wish to invest in such a scheme that would offer me good returns. I am looking to invest just for an year. So i have shortlisted the following

    1) Can Robeco Emerg-Equities (G)
    2) Franklin Build India Fund (G)
    3) Reliance Small Cap Fund (G)
    4) UTI Mid Cap (G)
    5) Reliance Tax Saver (ELSS) (G)

    All these funds are offering close to 100 percent returns when invested for a year. I am looking at investing close to 70000, so please tell me if i should go ahead or how should i plan this investment. Since i am new, i am not sure how to plan ahead…. KIndly suggest me on how i should take it forward. If u have any idea on other schemes, kindly let me know

    Thanks in advance

    Reply
    1. pattu

      If you are planning to invest for just an year, stay away from all mutual funds and invest in a FD or RD. Before using mutual funds please recognise how much the returns can vary.

      Reply
    2. Abhijith Manohar

      Prashant,

      Not Pattu sir but I will try to answer your question.

      Q1. Do you know what is an ELSS fund? What is the difference on Large-cap, mid-cap and diversified fund? - If you don't know what these are, your first step is to read what these funds are, which companies they invest in, how they manage risk and so on. Please do no invest without reading up on these details.

      Q2. These funds have returned 100%.. But, if the market falls tomorrow, they might lose 70% of their value. So if you invest 10000, after a year, you could be left with just 3000. Are you ok with that?

      Except the last one in your list the others are mid-cap funds which invest in small companies. These stocks take a very big hit if and when the market goes down. So if you don't like seeing your investments down after a year, you should not invest in them. This is not to say that they will not rebound - but there is no certainty that they will return 100% next year as well.

      Moreover, you should invest in equity mutual funds based on your goals, that is based on when you need the money. Do you need that 70k after 1 year? Equity mutual funds are not for you. Do you need that money after 3 years? Equity mutual funds are still not for you because they carry the risk that they may not give good returns after 3 years (if market goes down). Do you need the money only after 10 years? Then you should invest - but even then, not entirely only in equity.

      You should have the right balance of equity and debt. Here is more reading before you invest:
      http://businesstoday.intoday.in/story/tips-for-safest-diverse-investment-portfolio/1/17251.html

      http://freefincal.com/step-by-step-guide-to-selecting-a-mutual-fund/ Pattu sir's guide to selecting a mutual fund

      http://money.livemint.com/LiveHome/ValueResearchOnline.aspx A list drawn up by Mint newspaper.

      Remember - even if you invest in particular mutual funds others recommend, you and only you are responsible for the positive or negative returns. Returns from past cannot be expected in future.

      Hope that helped.

      Reply
  10. Prashanth

    Hello Pattu sir, this is prashanth. I have a query …. I am actually new to mutual funds, i wish to invest in such a scheme that would offer me good returns. I am looking to invest just for an year. So i have shortlisted the following

    1) Can Robeco Emerg-Equities (G)
    2) Franklin Build India Fund (G)
    3) Reliance Small Cap Fund (G)
    4) UTI Mid Cap (G)
    5) Reliance Tax Saver (ELSS) (G)

    All these funds are offering close to 100 percent returns when invested for a year. I am looking at investing close to 70000, so please tell me if i should go ahead or how should i plan this investment. Since i am new, i am not sure how to plan ahead…. KIndly suggest me on how i should take it forward. If u have any idea on other schemes, kindly let me know

    Thanks in advance

    Reply
    1. pattu

      If you are planning to invest for just an year, stay away from all mutual funds and invest in a FD or RD. Before using mutual funds please recognise how much the returns can vary.

      Reply
    2. Abhijith Manohar

      Prashant,

      Not Pattu sir but I will try to answer your question.

      Q1. Do you know what is an ELSS fund? What is the difference on Large-cap, mid-cap and diversified fund? - If you don't know what these are, your first step is to read what these funds are, which companies they invest in, how they manage risk and so on. Please do no invest without reading up on these details.

      Q2. These funds have returned 100%.. But, if the market falls tomorrow, they might lose 70% of their value. So if you invest 10000, after a year, you could be left with just 3000. Are you ok with that?

      Except the last one in your list the others are mid-cap funds which invest in small companies. These stocks take a very big hit if and when the market goes down. So if you don't like seeing your investments down after a year, you should not invest in them. This is not to say that they will not rebound - but there is no certainty that they will return 100% next year as well.

      Moreover, you should invest in equity mutual funds based on your goals, that is based on when you need the money. Do you need that 70k after 1 year? Equity mutual funds are not for you. Do you need that money after 3 years? Equity mutual funds are still not for you because they carry the risk that they may not give good returns after 3 years (if market goes down). Do you need the money only after 10 years? Then you should invest - but even then, not entirely only in equity.

      You should have the right balance of equity and debt. Here is more reading before you invest:
      http://businesstoday.intoday.in/story/tips-for-safest-diverse-investment-portfolio/1/17251.html

      http://freefincal.com/step-by-step-guide-to-selecting-a-mutual-fund/ Pattu sir's guide to selecting a mutual fund

      http://money.livemint.com/LiveHome/ValueResearchOnline.aspx A list drawn up by Mint newspaper.

      Remember - even if you invest in particular mutual funds others recommend, you and only you are responsible for the positive or negative returns. Returns from past cannot be expected in future.

      Hope that helped.

      Reply
  11. Kimi

    I am not sure if your figures on Nifty PE are right. That is because it appears you may have taken PE at a standalone basis. You need to take it on a consolidated basis. What is shown in the NSE website, if you pivked data from there, is the standalone PE.

    Thanks,
    Kimi

    Reply
  12. Kimi

    I am not sure if your figures on Nifty PE are right. That is because it appears you may have taken PE at a standalone basis. You need to take it on a consolidated basis. What is shown in the NSE website, if you pivked data from there, is the standalone PE.

    Thanks,
    Kimi

    Reply
  13. Abhijith Manohar

    I agree with you Pattu sir, these graphs indicate that for a long-term investor, PE carries little meaning, it is better to invest now rather than later and inaction makes us miss a lot of the action in the stock market.

    Reply
  14. Abhijith Manohar

    I agree with you Pattu sir, these graphs indicate that for a long-term investor, PE carries little meaning, it is better to invest now rather than later and inaction makes us miss a lot of the action in the stock market.

    Reply
  15. learningcurve

    nifty pe - is it anyway relevant to mutual fund investing...?
    my understanding is nifty index pe is arrived at by taking consolidated eps of all the constituents of index. if one wants to know pe of mf scheme, the right way is one has to calculate pe of individual schemes which is impossible at this moment unless mf house decides to publish it.
    Till such time, nifty pe may be guideline for trend followers or index mf schemes...otherwise this is purely academic exercise. has no relevance.
    you can correct if i am wrong.

    Reply
    1. freefincal

      It could be relevant from the point of view of tactical asset allocation. Extreme values (high and low) of the Nifty PE (so far) reasonably reflect the state of the entire market. Mutual funds PE should not be used for investing.

      Reply
  16. learningcurve

    nifty pe - is it anyway relevant to mutual fund investing...?
    my understanding is nifty index pe is arrived at by taking consolidated eps of all the constituents of index. if one wants to know pe of mf scheme, the right way is one has to calculate pe of individual schemes which is impossible at this moment unless mf house decides to publish it.
    Till such time, nifty pe may be guideline for trend followers or index mf schemes...otherwise this is purely academic exercise. has no relevance.
    you can correct if i am wrong.

    Reply
    1. freefincal

      It could be relevant from the point of view of tactical asset allocation. Extreme values (high and low) of the Nifty PE (so far) reasonably reflect the state of the entire market. Mutual funds PE should not be used for investing.

      Reply
    1. freefincal

      I see no reason how the PE of a scheme will help in investing in it. If I know enough to worry about things, might as pick my own stocks.

      Reply
    1. freefincal

      I see no reason how the PE of a scheme will help in investing in it. If I know enough to worry about things, might as pick my own stocks.

      Reply

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