In one of my recent posts about why I want Indian elections of 2014 to fail, I mentioned that due to recent run up in stock markets, experts were regularly coming out with one big target after another for Sensex.
Though I hate speculation, the fact is that we are all humans and its unavoidable. I hate it but I speculate every now and then. Very recently, I was fortunate enough to double my investment in MCX in just few months after company’s parent was caught in a crisis. Another stock which I believe can surprise in times to come is SAIL. I did two very detailed posts on why it was a good time to accumulate cyclical stocks like SAIL last year (2013). I still stand by that speculation. 🙂
Anyways, this post is a reaction to a report from a reputed research house, which thinks that Sensex would reach 40,000 soon. (Source)
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| Such Headlines are becoming common these days (Read: rising markets) |
How soon?
If they had said 5 years, it would have meant a reasonable growth rate of 12.5% from current levels of 22,500. And this would have seemed quite achievable considering that chances of India getting a good, business-friendly political environment for next 5 years are pretty high.
But according to the news item, analysts of this research house feel that Sensex would reach 40K in less than 2 years!! (Between 18 and 24 months to be precise)
This means a compounded annual growth rate between 35% and 48% for this period.
Is it possible?
I think it’s a little too optimistic and the research house is being Irrationally (Very) Exuberant. The current P/E multiple for indices like Sensex and Nifty stands at 19. And in case this target of 40,000 was to hold true by end of 2015, it would mean that earnings of constituent companies would have to grow at a rate in excess of 40%, just to keep the P/E of index at 19. And that too for two consecutive years!!
Now here we need to note two things:
- P/E ratio of 19 is not cheap.
- Earnings cannot grow at 40% for two consecutive years (Its not impossible, but its very tough)
Now, P/E Ratio for stocks (and indices) are calculated using below formula:
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| Formula used to calculate P/E Ratios |
So, in case earnings (denominator) don’t grow by 40%; but index (numerator) continues to grow at a rate in excess of 40%, then this would result in expansion (increase) in P/E ratio. This would mean that Sensex would become more expensive than current P/E ratio of 19. And stock market history tells that P/E multiples in excess of 20 to 24 are unsustainable and markets correct after reaching such levels.
But does it mean that Sensex cannot reach 40K in next two years?
No. Anything is possible.
But common sense says that its better not to believe the so called expert opinions which sound to good to be true.
What do you say?
Fully Agreed
i have already sold most of my equity, now waiting for pe of 16
🙂 Lets hope that markets correct and give us buying opportunities
Seems like a good move Dr Puneet. Better to be defensive in times of over-optimism.
Rgs SAIL. I think you must pay attention to its EPS. It is a very sensitive ratio and it is dwindling. It is a danger sign. The company may not go belly up, but surely it will test its all time lows again and WILL go below Rs.10. I don't see any other way.
Dev, reading one of your posts about PE ratios provided a significant step up in my learning curve. I feel indebted to you for that.
In several of your recent posts you talk about greed and fear. I still don't see any widespread greed. Lunch conversations at work never involve stocks. None of my colleagues has a list of stocks they recommend. In fact even if I mention stocks, people just change the topic. I see more fear than I see greed around me.
Yes, the market is going up, but I think we have a long way to go before we reach the greed zone.
After 5 years of reading all that I could read, I have come to a conclusion that by just “Rupee Cost Averaging” and “Periodic Re-Balancing” I can end up in top 1 percentile of market participants in terms of the annual rate of compounding of my net worth.
PS: I don't own any stocks, I am just SIPping mutual funds over the past year and I intend to stay the course.
Hi Amit
In my 2-part article on SAIL, I expected and mentioned a worst case scenario for SAIL to be in range of Rs 30 and Rs 40. And the shares have already tested those levels.
But like you, even I dont expect the company to close down anytime soon. In case it does go down to levels lower than 40, I might gladly load up more shares and wait to exit at higher levels. But I am pretty sure, that when demand for steel catches up with supply, the shares of SAIL will see better days.
Anyways in my personal portfolio, I try not to keep cyclicals as core holdings. These are more of a medium term conviction calls which I might exit when they give a decent CAGR. 🙂
Thanks Kalyan 🙂
The greed part of stock markets might not be as horrific currently as it was in 2007-2008. But in case this unabated and over-optimistic rally continues for a while, then its possible that greed will start finding a lot more place at dinner table discussions than it currently is. 🙂
And you are spot on with your observation of Rupee Cost Averaging and Re-balancing. A simple and common sense based approach is more beneficial in the long run than complex ones. And SIP as a core method of investment is the way to go for average investors like us.