Is a market crash near?

Be fearful when others are greedy. Be greedy when others are fearful. -Warren Buffet

Markets are near record highs as I write this article. Such euphoric conditions make me wonder if it is time for me to be fearful. So I looked into the past for precedents and what actions would have been wise in such situations. Results are eye-opening!

I will try to provide a 360-degree view and let the readers make their own informed conclusions.

1. NIFTY PE

PE refers to the Price Earnings Ratio. It is a measure to understand how reasonably the markets are valued. A higher overall PE denotes overvaluation (assuming other factors are constant).

• The PE in the image refers to the trailing NIFTY 50 PE
• The percentages shown represent the average leading returns post the recorded PE for 1 year, 3 years & 5 years respectively.
• Returns above 1 year have been annualized

I have used a reasonably long period to calculate the above (1/4/03 to 23/4/19) so that the results are not skewed. To make the results even more accurate, the data chosen for analysis is the daily data rather than the monthly/quarterly data.

The trend is very clear from the above image. Higher the PE, lesser the returns.

The current NIFTY PE is ~29. That is even more than what we have seen in 2008 before the crash. The row which calls for attention is the last row in the image above. Historically, when Nifty PE was greater than 26, the average annual returns were -9.3% for 1 year, -0.8 for 3 years and -0.6% for 5 years.

Wouldn't reducing equity exposure amount to timing the market?

It does amount to timing the market. However, interesting thing to note here is, had someone invested at PE > 26 and followed the philosophy of spending time in the market rather than timing the market, he might be staring at a loss even after 5 long years of investment. Being a Warren Buffet follower, this comes as a shock to me.

Shouldn't we be looking at Forward PE to make our decisions?

Investors invest in markets on the expectations of companies doing well. In that sense, forward PE should be better. However, forward PE is based on forecasts which aren't always reliable. In euphoric market conditions, it is observed that growth is extrapolated beyond points where it is realistic. Therefore trailing PE becomes more reliable in such cases.

Let's look at other factors which are affecting the market

2. FII Flows

The FII flows which have fueled the recent market rally since March 2019 are indeed a double-edged sword. While the quantum of money pumped in makes the markets shoot up, it is equally responsible for market fall when the money is pulled out.

Also, FII money isn't sticky money. Slight scare in the fundamentals may trigger a pull-out.

3. China's recovery

Given the trade tension between US & China and lack of clarity on Chinese recovery, the Global wealth marked for developing markets was largely diverted into India. However, if there are better signals of Chinese growth amidst easing US-China trade war tensions, it may become a preferred destination for FIIs. Which may lead to the fall in Indian markets.

4. Political Scenario

The ongoing election poses a big event risk for the markets. The markets seem to have factored in a stable majority government. So, any form of a surprise there may give reason to the market participants to book their profits and move out.

It is said, "Buy the rumours, sell the news". So in any case, the market might see selling pressure if market results are up to expectations. To be fair, markets might go up further if election results are better than expected.

5. US Recessionary concerns

Being the reserve currency of the world, the US has leveraged its economy to an unsustainable level. While people usually talk only about Federal debt, I would like to point out that corporate debt, as well as consumer debt, are adding massively to this bubble. Everything looks good as long as the bubble is growing. The notable bubble bursts like the 2008 financial crisis and the 2000 dot com bubble, all coincided with high debt to GDP levels. Sadly, the US economy is once again at that stage. While they have managed to stay afloat without changing the financial fabric for a decade, it will eventually meet the same fate. The question is not whether or not, but when? Cheap money, increasing debt levels, and an inflationary economy is giving an illusionary rosy picture. However, when such bubbles burst, everything falls like a pack of cards.

Do this imply it is all going to be downhill from here?

The stock market isn't exactly a homogenous mixture of stocks. It's a combination of some that are overvalued and some that are relatively undervalued. In order to provide a holistic view, I will also list reasons which support staying invested in the market and let you, the reader, decide on the decision you would like to make:

1. Pockets of value

While Nifty has run up on the back of some stocks, the broader markets (Mid & Small Caps) are still not as richly valued. Even in the Nifty 50, some companies are not exactly overvalued which may be studied.

2. Growth in India Inc

The markets are predicting a phenomenal growth in earnings from a lot of companies. If this does happen, the NIFTY PE will fall owing to a larger base effect. However, even if there is a growth of 10% in earnings QoQ, Nifty PE will fall to ~26 which I believe is still richly valued. India Inc will have to post many quarters of such growth without much increase in price levels to justify the current valuations.

3. PE not an accurate measure

Financial services form roughly 40% of the Nifty 50. And PE is not the right ratio to judge the financial services sector. So, some argue that PE based analysis must be taken with a pinch of salt.

4. PB Ratio of Nifty

While the NIFTY PE is making new all-time highs, the PB ratio shows a completely different picture. The PB ratio is another measure that analysts use for valuing the market. It is currently at 3.7 while the market peak is over 6. PB is a better ratio to gauge financial services (40% weight).

What should one do in such a scenario?

As I had written at the start, I have written arguments on both sides so that readers can make their own conclusions. However, there is a segment of investors, who need not worry about all of the above.

1. SIP investors- continue investing. A market downturn will benefit you if your horizon is long. In case the markets do fall, you can also think about increasing your SIP amount.
2. Investors with Long Term horizon (>10 years) - This downturn will again have little bearing on you. If you are however nearing the end of your horizon, you have a decision to make.

P.S: Those who are confused, and aren't able to make a decision, either broaden your investment horizon or mitigate your risk. Such risk may be mitigated through either of the following actions:

• Try to find the pockets of value in the market or find someone who can find it to your satisfaction.
• Move into defensive stocks
• Reducing the equity percentage in the overall portfolio
• Buy Nifty put options to hedge the portfolio.

Looking to make a fresh investment?

I would advise waiting for some consolidation (at least 5-10%) before entering the market. I expect it to happen in the coming 2-3 months. You may park your money in short term debt instruments/ arbitrage funds till then.

I encourage readers to express their views about the current markets in the comments. If there are any queries, again, write in the comments. I will try to answer them. Any form of feedback good or critical is much appreciated. Do share this article with those who will benefit from this article.