With the recent 8.2% run-up in the market, the valuations are back to their historic averages. Inflationary concerns and higher interest rates had kept the market at tenterhooks, leading to the stock market trading at a discount to its historic valuations.
Pumping in of $2.24 billion by foreign investors in the last nine sessions has brought valuation of Sensex companies back to its long-term averages. According to Nilesh Shah of Axis Bank, this rebound was imminent given that the all the near-term headwinds were all factored in at those levels. ?India definitely appeared at a valuation advantage during the last leg of market decline,? he said. The current P/E (trailing 12 months) of Sensex at about 20.1 is in line with five year-rolling average of 20 and long-term average (since 1994) of 19.7.
A look at the the past movement of PE ratio (trailing) vis-a-vis that of the market indicates that the market consolidation phase seen now for the market is similar to occurrences in October 2004 and June 2005 when the market valuation bounced back to their benchmark averages after trading at a discount for a period of four to five months. Since then, Sensex appreciated 239% before the market crashed in January 2008. Experts say the rebound may sustain an upmove with Sensex even touching all-time closing highs this year, as expected by many foreign brokerage houses.
As against a consolidation phase, when valuations tend to quote below averages for shorter period ? say four to five months, in case of a market trend reversal (be it start of a bullish or bearish trend) ? there have been many instances of longer periods of below or above average market valuations. For instance, during the last two major bear markets (2001 and 2008), valuations traded at a discount for a period of 2.5 years and one year, respectively, before coming back to long-term averages. Similarly, during the last two major bull runs (2003 and 2009), valuations have traded at a premium to long-term averages for a period of 2.8 and 1.5 years, respectively.
Also, equity markets tend to behave in an interesting fashion around its medium (rolling five years) and long term (since 1994) averages. It is seen that Sensex valuations tend to extend their decline only after falling below both these averages and widen their rise when they manage to overtake both these benchmark averages.
While the expansion or decline in valuations may largely be a factor of the underlying market trend, the liquidity in the system also tends to impact the valuations, says R Sreesankar, head of institutional equity at Tata Securities. ?Valuations in general has seen a higher impact of liquidity in the system. In a scenario of higher liquidity and low inflation, the PE multiple tends to expand due to an impact of the impulse purchases,? he says.