PE Ratio — a short love story
Like a lot of beginners, I picked up a few books on investing in the stock market before I even invested a rupee. My go to book for value investing was the simple to understand — “Value Investing and Behavioral Finance: Insights into the Indian Stock Market Realities” By Parag Parikh. One of the first lessons was having faith in the PE ratio, which is the Price to Earnings ratio of the entire market.
PE Ratio = Market Value Per Share/Earning per Share
A high PE ratio indicates a higher confidence in the market and economy in general and indicates that the share price does not proportionately correlate to the earnings. Mr. Parikh asks investors to have blind faith in PE ratio and states that time and time again has indicated when the market will crash, and today it has proven once again to be correct.
I started playing around with the graphs and values comparing PE ratios on various portals and terminals starting from 1970s and it became clear that the market is over-valued and looking for a crash around 23–25 values, although sometimes the markets crashed almost immediately and some took a really-really-really long time. A look at what the PE ratio (NIFTY 50 of the NSE Index) was when markets crashed in recent memory (source: nifty-pe-ratio.com) —
2002 “Dot Com Crash” — 27.12
2008 “Sub-prime lending Crash” — 26.55
2010 “Correction” — 25.23
2019 “Covid-19 Epidemic Crash” — 29.25
The fascinating thing about the ongoing 2019 crash was that the markets sustained a Higher PE ratio beginning January 2017 till January 2020. For 3 years the market has been highly overvalued, however a variety of factors sustained the markets such as a huge inflow of SIPs from retail investors, inflow of Foreign Institutional Investors and a faith in the bull run.
A lot of times, I as a devout believer expressed my doubts about the PE ratio, when I kept looking like a fool for publicly stating that the markets will crash at any moment now but every time the markets climbed higher and higher. I did finally pull out around May 2019, after a quick calculation of my tax payable and being satisfied with my overall returns, however I regretted it immensely seeing that my stocks would’ve made much more money had I sold in December 2019. Like a lot of novice investors, I tried to time the market with relatively minor success, believing that I cracked some sort of secret code only to be faced with regret and falling out of love with the PE ratio.
In my opinion, the market crash or a correction was long pending since October 2018, and whether for the Corona Epidemic or not the market would’ve crashed sometime this year if not March of 2020. In a weird sense the ruling Governments all over the world areprobably relieved that the market crash would be blamed on the Panic of the Epidemic, but then again who can it be ever blamed on? The markets is an unpredictable beast and the only tool I will trust to tame it is the PE ratio.
If you are looking to invest now (whether in stocks or mutual funds), wait for the PE ratio to drop to around 15 or lower, as on date the PE ratio stands at 17.15, you can keep a track of it at nifty-pe-ratio.com or trendlyne.com/
