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A 133 year lesson on how to prepare for the current bull market

Dec 8, 2014

In this issue:
» Companies with the most valuable promoter stake
» Pace of reforms a big let down
» Dow Jones continues to make new highs
» ...and more!


00:00
 
Stock market veterans will recognize this as the eternal debate: Is there really any relationship between valuations and the movement of stocks?

And if the answer to this question in not firmly clear in your mind, it may be dangerous world out there for you. Why?

Because it is exactly times like these, when stock prices are rising every day, that there is no dearth of players in the market who will try and convince you that valuations have little bearing on stock prices. And that just about any time is a good time to be buying stocks for the 'long term'. So someone who does not have a definitive answer to the above question becomes vulnerable to such deceptive theories.

So what is the real answer?

Well, the answer has 2 parts actually. In the short term - the answer is a most definite no. Valuations and the movement of stocks may have no relation whatsoever in the short term. Whether stocks are expensive or cheap at any given time tells you nothing about whether they will go up or down in the short run. Expensive stocks can always become more expensive, and cheap stocks cheaper still.

But it is the second part of the answer where things start to become really interesting. For in the longer term, there is a definite and established relationship - on average, the more expensive the stock, the lower the future returns.

And there is a lot of anecdotal data to back such a conclusion.

Just recently, the guys over at New York Times presented a study of the US's benchmark S&P 500 stock index since 1881. Now that's 133 years of data! So one better take the results seriously.

What the study reveals is that wherever the S&P 500 has had a price earnings (PE) ratio of at or above 24, the average return over the next 10 years has been a negative 3%. In stark contrast, the average 10 year return over this entire 133 year period has been about 36%. In other words, had one avoided the markets whenever the S&P 500's PE ratio was above 24, his average return over any 10 year period would have been much more than 36%.

So valuations matter, and they matter a lot. If anything, history only proves that while there may be short periods of time when stocks are expensive but still rising, the odds are stacked well against the investor who buys his stocks at expensive valuations.

As a matter of fact, when we conducted a similar - but not as exhaustive - study on the Indian markets, the conclusion wasn't very different. And we used what we believe is a more reliable parameter than the PE ratio. The dividend yield that is. So, whenever the dividend yield of the Nifty went below 1.14%, the returns over the next three years turned out to be quite poor. But as the yields went higher and higher, the returns kept getting better and better on a CAGR basis. So much so that at close to 2% dividend yield on the Nifty (the dividend yield currently is about 1.24%), the average returns over the next three years came to as high as 40%! Looks like buying cheap really pays, whether it be India or the US.

Surely a lesson to remind ourselves even as our indices make a habit out of scaling new highs every week or so.

What do you think about the relationship between valuations and the returns from stocks? Let us know your comments or share your views in the Equitymaster Club.

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02:30
 Chart of the day
 
With this incessant rise that the stock markets have been seeing of late, the promoters of many companies have seen their wealth multiply manifold. We present to you today a chart of the 10 highest promoter holdings in India by value. Topping the list is Tata Group company TCS, thus giving the Tata Group the privileged position of being the holder of the most valued promoter stake in any single company in India.

A report in the Mint newspaper points out that the promoters of listed companies, including the government, are sitting on a combined stake valued at upwards of Rs 50 trillion in terms of market capitalization as of September end. Good times indeed for most in corporate India.

Companies with the most valued promoter holdings

03:05
 
An attempt to justify the current rally in stock markets does not just stop at valuations. It is true that taking into account the historical valuations of Indian indices, we are still away from the peak. However, does that mean the stock markets will continue to move in the upward direction? Well, a rational approach tells us that investors would want to do a reality check while investing at current valuations. And the reality can be in terms of earnings expectations as well as big ticket reforms that could change the investing landscape. Now as far as earnings estimates are concerned, we can tell you that the September quarter results offered no positive surprises. Rest assured the remaining quarters of FY15 are unlikely to offer reasons to cheer as well. With most of the planned capex yet to take off, it will be sometime before India Inc witnesses big ticket earnings growth.

Meanwhile, the fact that the reforms being executed by the current government are only a fraction of those promised is a big letdown. It is true that the government is just 6 months old. However, its unwillingness to risk its political strengths to execute painful reforms is being perceived negatively. Hence with the euphoria of the new government having died down, the reality check is giving investors reason to worry. And it is only a matter of time before Mr Market gets a whiff of this fear. Needless to say, the valuations that are mostly backed by greed currently could nosedive as and when the greed is replaced by fear. For long term investors though, such an event would be worth waiting for!

03:45
 
It's not just the Indian stock markets that are skating on thin ice. The Dow Jones continues to make new highs every week, even as US' Debt to GDP ratio gets alarmingly bloated. Just as FII buying is keeping Indian markets buoyant, central banks in the US and Europe are keeping the liquidity tap overflowing. Just the other day we told you how Alan Greenspan, the grandfather of America's QE, believes that all bubbles should not be preempted. It seems his successors too are in no mood to stop printing money. And the possibility of the US Fed raising interest rates is nowhere near. Hence, the stock markets in the US and Europe continue to remain in an inebriated state. Investors there too are in no mood to reconcile the difference in the economic prospects with the stock market valuations. At this stage, we recall what Ajit Dayal had written in the Honest Truth exactly 3 years back - "The hangover will only get worse. The pain will only be lengthened. The US Dollar - and the US economy - will be set for a longer and steeper fall. And jittery traders will make the stock markets yo-yo more than it already does."

04:45
 
The Indian stock markets were trading weak today on the back of sustained selling activity across most index heavyweights. At the time of writing, the BSE-Sensex was trading down by around 330 points. Losses were largely centered around IT and telecom stocks.

04:55
 Today's investing mantra
"Investors making purchases in an overheated market need to recognize that it may often take an extended period for the value of even an outstanding company to catch up with the price they paid." - Warren Buffett

This edition of The 5 Minute WrapUp is authored by Tanushree Banerjee and Taha Merchant.

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2 Responses to "A 133 year lesson on how to prepare for the current bull market"

paresh shah

Dec 12, 2014

Could you provide the link to the New York Times article.

Like 

selvaraj

Dec 8, 2014

Sir, It was told 3 years ago that The hangover will only get worse. The pain will only be lengthened. The US Dollar - and the US economy - will be set for a longer and steeper fall. And jittery traders will make the stock markets yo-yo more than it already does."
but see what happened in 3 years. Do people change with time? Does the government has any tool other than interest rate to keep the people Hope alive? Are there any indicator other than stock index to look forward to ascertain the hope?

Like (1)
  
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