Over the last 1 year, we have seen the 2 extreme sides of the stock market. During COVID, Sensex tanked almost 40% from the level of 42,000 to the lows of 26,000 and Nifty tanked from the highs of 12,000 to the lows of 7,500 creating huge panic among investors. And then some magic happened. Sensex and Nifty saw the rally of their lifetime where Sensex rose from 26,000 to current level of 52,000 which is 100% jump and Nifty rose from the lows of 7,500 to current level of 15,300 which is also a 100% jump. All that happened within a span of 1 year.
Now there are 2 sets of people in the market:
1st set of people are those who are relatively new investors and entered into the stock market after the recent rally. They are highly optimistic people and have invested all their money into the stock market. Probably because they haven’t seen any bear market or never witnessed stock market crash.
2nd set of people are those who have been into the market for a long time and understand the game of valuation. They know that the markets are overvalued and hence they have not invested into the market or completely exited from the market with a hope that the market will correct in the future and they will reinvest.
Now the biggest question is - Who is right? The 1st set of investors who think that this is the rally of the lifetime and the golden opportunity to create wealth from the stock market? Or the 2nd set of people who have exited completely from the market as they think that market is overvalued?
This is the 2nd episode of “Let’s learn investment” where we will discuss the “hot topic” of stock market - Is Indian stock market overvalued? If yes, then what should be the right strategy to balance the portfolio?
So I have divided this topic in 2 parts:
In the 1st part, we will discuss - How to identify if the stock market is overvalued? Then we will discuss, if it is overvalued then why is it overvalued? What is the reason?
In the 2nd part, we will discuss - As an investor what should be the right strategy to balance the portfolio when investing in the stock market.
Alright, let’s get started.
Is the stock market overvalued?
Is the Indian stock market overvalued? This is a very common question these days. On one side, the entire country is still trying to recover from COVID pandemic and the GDP has shrunk 24% in Q1 & 7.5% in Q2 of FY21. But on the other side, the stock market in India has doubled from the lows in March 2020.
But why did the stock market behave in an opposite manner? Ideally, if the economy is falling, stock market should also fall as the stock market is eventually dependent upon the companies performance which is dependent upon the economy.
We will get back to this question of why the stock market behaved in an opposite manner. For now, let us 1st understand - How the heck we can figure out if the stock market is overvalued or undervalued?
So there are 2 ways to identify the valuation of stock market:
1st way is via PE ratio and 2nd is via Market cap to GDP ratio or also known as Warren Buffett indicator.
Let’s 1st start with PE ratio.
PE ratio is the ratio of price per share to earning per share. Now, what exactly is PE ratio and why it is important? We will not get into these details. I will create a separate video on that. For now, just understand that PE ratio is an important parameter to gauge the valuation or a company or entire stock market.
Historically, the Nifty PE ratio ranges between 15-25. If it falls below 20 then you can say that stock market is undervalued. If it reaches near 25 then you can say that stock market is overvalued.
For example, during the 2008 financial meltdown, the Nifty PE reached a peak of 28.29 just before the US housing bubble. And then, after the stock market crash, Nifty PE fell down to the PE of 10.68. When Nifty PE was at the peak of 28.29 in Jan 2008, Nifty was trading at a peak of ~6,200. After the crash, Nifty fell down ~60 % to 2600 and at that time the Nifty PE touched 10.68. So clearly, the market was overvalued before the crash when Nifty was at 28.29 and became undervalued after the crash when it touched a PE of 10.68. Although, these are 2 extreme sides. Nifty PE would normally swing at ~20-24 where you can say that it is fairly valued.
In fact, if we take the recent example of COVID, Nifty PE was at the level of 29.9 in Jan 2020 before the market crash. And after the market crash in Mar 2020, Nifty PE touched a low of 17.15 making it undervalued.
Do you know what is the current PE ratio of Nifty 50?
If you just search the PE ratio of Nifty 50, you will find that the current PE ratio of Nifty 50 which represents the top 50 companies of India or almost 67% of total market cap of all listed company is 41.65.
That’s insanely high!
There is one more parameter to gauge the valuations. It is Market Cap to GDP Ratio or also known as Buffett Indicator. In simple language, this indicator suggests what is the valuation of the stock market as compared to the entire GDP.
For Indian market, the Market cap to GDP is normally around 75%. It means the Indian stock market valuation is 75% of Indian GDP. And that’s a fair valuation. However, recently, it has touched the level of 100%. In fact, in the US, the Market cap to GDP ratio is generally around 100%. However, currently, this ratio has touched an insane level of 200%.
So both PE ratio and Buffett indicator clearly suggest that the stock market is overvalued.
Now let us understand the reason for such high valuation.
There are mainly 2 reasons: 1st reason is that due to COVID, there was a sharp fall in earnings which is the denominator of PE ratio. Now, if the denominator would fall, obviously the PE ratio would increase. In the future, as the economy would recover, the earnings would increase and that would result in lowering down the PE ratio.
Now, there is a 2nd reason for such high PE. It is due to exorbitant rise in the share prices.
And why did share price rise when the economy tanked?
To understand this, you need to know the dynamics of the US market. So India is a big market for US investors as they invest a lot of money via FII or Foreign Institutional Investment. Hence, Indian stock market movement depends a lot on foreign investment. Although, today we also have domestic institutional investors that also impact the stock market movement. But, there is still a lot of dependence on foreign investment.
Oflate, there is a significant inflow of FII money in the Indian stock market. This is mainly due to huge amount of liquidity in the US market as the US Fed has printed Trillions of US dollars. This has resulted in a lot of liquidity and the fact that the US Fed has reduced the interest rate significantly. Interest rate is the key here. Governments use this interest rate to accelerate the economy or put a brake on it. For example, due to COVID, there were a lot of job losses, so the US fed lowered interest rates to as low as 0.25% so that businesses can borrow money at a cheaper rate and generate employment. Also consumers can borrow money at lower rates and spend more. So both factors including trillions of dollars of stimulus and lower interest rates have resulted in a huge inflow of money in Indian market and this has resulted in increase of share price in India. So, I hope you got the reason why the share prices in India or Indian stock market is so high. It is because of a lot of inflow of foreign investment.
Now the question is - Will this rally continue or if not, when will it end?
To put it in a simple language, we can say that once the US investors or FII start withdrawing the money from Indian market there will be a correction in the stock market.
But when will the FII pull money?
They will pull money when there will be an increase in interest rates from the US Fed. US fed would eventually increase the interest rate when the inflation would increase due to high liquidity. When there will be an increase in interest rates, there will be a crunch of liquidity in the market. And this would result in US investors pulling back their money from Indian market.
So, if we summarise the entire story. One of the major root causes of such high valuations in Indian market is due to heavy inflow of foreign investment in Indian market and that is due to very high liquidity in the US market which is again due to very low interest rates.
In the future, due to high liquidity, there would be an increase in inflation in the US. At that time, US fed would have to increase the interest rate. And that would trigger the correction in the stock market.
The only problem is - We don’t know when will the US Fed increase the interest rates. It can happen tomorrow or in the next 1 month or in the next 1 year.
What should you do in this situation? Should you invest or should you exit?
That takes us to the 2nd part of this article where as an investor what should be the right strategy to balance the portfolio when investing in the stock market or mutual funds.
Personally, I follow the strategy from Mr. Benjamin Graham. I am not sure if you are aware but he is none other than the Guru of Mr Warren Buffett, who is known as god of investing.
In 1949, Mr Ben graham wrote a classic book that became the foundation of value investing. The book is named “The Intelligent Investor”. In that book, he has mentioned the golden strategy of investment which I personally follow.
He says that, “Nobody can time the stock market.” So those new investors who think that markets will never fall and they have invested all their money are wrong. When market rises to extreme levels, it will always correct in the future. And those who think that the market is overvalued and they have exited their entire investments are also wrong.
It is because if there is a correction in the market, new investors would surely lose the money. But, the investors who exited from the market would try to enter at some level. But the problem is- what should be the right level to enter? Nifty at 12k, 10k, 8k or even below? In fact, during the market crash in Mar 2020 when Nifty fell down to 7600 due to COVID, many investors didn’t invest their money thinking that Nifty would touch 6000. And when the market recovered, they regretted not investing. So basically, it is impossible to time the market.
Hence, it is very important to make a fine balance. Don’t be too optimistic and don’t be too pessimistic. The intelligent investor book suggests that you should make a balance between equity and debt in a fixed ratio and keep rebalancing based on market situation. For example, if the market is overvalued, like in the current case, then you should have more exposure in debts and lower exposure in equity. For example, you could have 25% exposure in equity and 75% in debt. Or 50% in both equity and debt. And when the market becomes undervalued like during the March 2020 crash, you should increase your equity exposure to a maximum of 75%.
I have personally invested 50% of my money currently in equity and rest 50% is in debt. If the market becomes more overvalued, I would reduce my exposure in equity even further. And if there is a good correction and the market becomes fairly valued or undervalued then I would increase my equity allocation.
So this is the golden rule that I have learned from the book “The Intelligent Investor”. Now, it is up to you to decide what is the best strategy for your investment. And tell me in the comment box how much allocation you have kept in equity? If you are a long term investor and invest every month, you can continue investing the money in a systematic manner so that you invest at all the levels even during the time when the markets are down so that it would average out your returns.
I hope this article would help you understand how to identify if the markets are overvalued and what is the reason for this overvaluation and what should be the right strategy to balance the overall portfolio.
In case, you want to learn everything about stock market, mutual funds, insurance, tax planning, in a structured manner, you can explore my video course. I will make a separate video on PE ratio and explain how to check the valuation of each company before investing your money. Till then, take care!