It is difficult to time the market. We all know that we should buy when PE (price-to-earning) ratio of Nifty is 12 and sell when PE ratio goes above 24. But to say that one can time the market on basis of just Index PE will be an over-simplification. If we look at the historical data, it clearly shows that whenever a market reaches either of these two levels, it seems to bounce off in the opposite direction. Clearly when a market is trading at 12-14 PE, fear is at its peak level and the market is considered undervalued. When above 22, the greed clearly is in the driver’s seat and the market is considered overvalued. On average, 36% of the time a market stays in range of 16-20 PE while 33% of the time in 20-24 PE range and 24% in 12-16 PE range.
Less than 1% of the time market stays below 12 and around 4% of the time market stays above 24. Nifty currently is trading at 24.27 PE. So does this mean we should not stay invested in the market and wait for it to come to its mean average of 16-20?
If one has managed to catch Nifty below 12 PE then returns for the year 3, 5, 7 and 10 are 38%, 29%, 22% and 19%. Returns for 3, 5, 7 and 10 for Nifty above 24 are -4.8%, 3.4%, 9.6% and 11.8%. Did you notice the pattern? When a market is in oversold condition, we get maximum return in the short term as market bounces sharply while in the long run, the averages tend to smoothen out the panic and we get decent return. However when a market is trading at high valuations, returns would be lower in short term as market tends to correct but in the long run investors tend to get good returns.
You might also want to see this:
So, returns depend a lot on where we have entered the market. While it is difficult to time the market, when to exit is in our hands. Let us say we invest for 10 years at levels of 24 PE at which currently market is trading. Maximum return we can get based on past historical data is 13.4% while minimum return is 10.2%.
So average return comes to 11.8%, which is decent since we have invested at the top end of the market. So, if you invest for less than three years at high PEs, you will get small or negative return. As investment horizon increases, the expected returns more or less are reasonably good enough, even when an individual is investing at higher PEs.
The writer is CMD, Tradebulls Securities.