How High Can this Market Go?

Back in the early 20^th century when the legendary Benjamin Graham gave lectures on investing, he was often spotted wearing a unique necktie.

Specially imported from Paris, this necktie had a nice chart like design on it.

It was later revealed by Graham himself that the tie was a gift from a dear friend. The design on it was the relationship between stock yields and bond yields.

This friend, who was also the head of a big brokerage house, was smitten by the idea that there's a close connection between stock yields and bond yields.

For more than 50 years, it was some sort of a rule on Wall Street that stocks should yield considerably more than bonds.

And whenever this relationship broke and stocks started yielding less than bonds, it was a sign that you were in a dangerous market - one heading for a bad fall.

Graham's friend who saw this rule work so wonderfully well in the past, automatically assumed that it would work in the future as well.

So he made it the cornerstone of his investment strategy. He started using it constantly in his market letters.

If you were to make a similar necktie in India, which ratio do you think should be printed on it? What is that single ratio that has warned you of a bad fall in advance?

I believe the top contender would be the Sensex PE ratio.

This is because it has proven to be a remarkably accurate indicator in all the big crashes of the recent past. Three of the biggest crashes in 21st century India have occurred at a Sensex PE ratio of between 25x-28x.

Be it the subprime meltdown, the dotcom bubble or the massive fall in Sensex early last year, all of them had the Sensex trading at a PE multiple of between 25x-28x at the top of the market.

So, should we go ahead and order a necktie with a Sensex PE of 25x-28x as a danger sign?

Well, not so fast.

Within a few years of coming out with his famous neckties, Graham's friend put a huge ad in the newspaper. It was about how he is abandoning his favourite concept of the relationship between bonds and stocks and that he no longer believed in it.

Shocking, isn't it?

His action seemed completely justified though.

At the time the ad came out, the indicator was flashing red for almost a few years. Yet there was no crash in sight.

In other words, stock yields had now gone lower than bonds but the big fall that follows this event was nowhere on the horizon.

He concluded that it was time to start looking for a new crash indicator as the current one had stopped working.

Well, what I have just highlighted is a story that's true of most stock market indicators.

They all work wonderfully well for a period of time.

But as enough people start using them and as external conditions change, they abruptly stop working.

Now, is this true of our own Sensex PE indicator as well? Has it stopped working?

Well, I can't say for sure, but I also can't deny the possibility. The Sensex currently trades at a PE multiple of more than 31 times on a trailing twelve month basis. This is much higher than the 25x-28x range that usually leads to a big market crash.

Thus, going by valuations and the Sensex PE ratio, a big fall in the market can come anytime now.

But the mood in the stock market is of anything but caution.

There seems to be unanimity that the bull market still has a fair distance to go. The party seems to be very much on.

So is it time to start looking for a new indicator for the Indian market as well?

I don't think so.

In fact, I am more in favour of totally abandoning this concept of a crash indicator. I prefer taking the opposite approach and assume that no one has any clue on how the markets will move and when is the next big crash likely to occur.

All I know for sure is that there is a big crash in the stock market every few years and I need to be ready for it in thought and action.

Therefore, if I have Rs 100 with me to invest, I will never put the entire Rs 100 into stocks. I will always keep at least 25% in bonds or fixed deposits and invest the rest in stocks.

If I think the market has turned expensive and the Sensex PE ratio is well past 25x-28x, I will put 50% or even as much as 75% in bonds or fixed deposits and keep the rest in stocks.

This way, even if the markets keep going higher, I will benefit because I still have some money in stocks.

If there is a significant crash, take advantage of the attractive valuations of the stock market. I can use my fixed deposits or bonds to take more exposure to stocks.

A lot of time and effort is spent by a lot of experts in predicting the exact time of the next stock market crash or finding out the next reliable crash indicator.

However, as I just showed, it's almost impossible to pull this off on a consistent basis.

A much better option is to be prepared for a stock market crash at all times.

At the same time, capitalise on the undervaluation or the overvaluation of the broader stock market by switching one's allocation between stocks and bonds.

Warm regards,


Rahul Shah
Editor and Research Analyst, Profit Hunter