As the PE ratio of Sensex soars to a 20-year high indicating extreme overvaluation, experts say that a stock market correction is in the offing, as such levels are unsustainable.
As the PE ratio of Sensex soars to a 20-year high indicating extreme overvaluation, experts say that a stock market correction is in the offing, as such levels are unsustainable. The Sensex PE has soared to 28.29 in FY20, it’s highest in the last 22 years. “The market is indeed overvalued at a PE of above 28. Markets are extremely fragmented at the current moment and Sensex cannot always remain in its fortified island at such high levels. There is very high likelihood that stocks will crack and correct to their mean PE levels within a short span of time,” Umesh Mehta, Head of Research, SAMCO Securities told Financial Express Online. The Price to Earnings (PE) ratio compares the market price of the share in relation to its earnings. The ratio implies the amount an investor is willing to pay to earn one rupee in earnings (profit). Therefore, if the PE ratio for Sensex stands at 28, investors are willing to pay Rs 28 for one rupee profit collectively earned by all companies that comprise the Sensex.
Explaining the reason behind the excessively high PE at present, investment advisor Sandip Sabharwal noted that losses reported by stocks like Tata Motors and SBI have skewed the ratio, which is unlikely to repeat in the future. “Sensex PE is misleading as over the years more and more high PE stocks have go added to the Index. Due to this the PE looks higher than what it would be in normal circumstances,” he noted.
Experts concur that the valuations remain stretched at the current levels. On one hand, few select large caps in key sectors like BFSI, IT and Oil & Gas which constitute majority of weightage in the index have been taking the markets higher, while the other sectors like Auto, Pharma, Metal and Telecom has already witnessed considerable correction over the past 1-2 years due to their respective challenges, Ajit Mishra, VP – Research, Religare Broking told Financial Express Online.
Notably, the top 10 index constituents have been getting a lion’s share of incremental flows from both domestic as well as foreign funds, says Jatin Khemani, founder and chief executive officer, Stalwart Advisors, an independent equity research firm registered with the Securities and Exchange Board of India. “This has elevated their multiples as well as that of the index,” Khemni told Financial Online, adding that the story outside the top index stocks is the exact opposite, as the broader markets have seen meaningful outflows contracting their multiple below the 5-year average. “The re-rating that happened over the last cycle has been completely washed away bringing valuation of broader markets back to reasonable levels,” he said. However, the Sensex PE ratio serves little purpose for the bottom up stock pickers, says Khemani. “What matters much more is the quality, growth outlook and valuation of companies one holds in his portfolio,” he added.
So what should investors do, to mitigate risk of a loss? “Investors should do systematic investment plan (SIP) in midcap funds or thematic funds like pharma sector funds as risk reward is favorable in those at current levels,” Vikas Jain, Senior Research Analyst, Reliance Securities told Financial Express Online. According to the expert, earnings have to catch up from current levels otherwise there will be price to earnings (PE) contraction which will lead to sharp correction in the Sensex. “Midcaps and small caps have witnessed deeper correction over the past one year as issues with respect to earnings decline, governance issues and sharp outperformance in CY17,” he said, adding that markets will keenly watch the first quarter earnings of FY20 and global issues with respect to trade war and higher crude prices from current levels, going forward.