Where does the index stand ?

Update 29th - I missed an important point when i posted on 28th. The data for the index is non-stationary. What it means that the underlying composition of the index is not fixed and the various other parameters such as interest rates, inflation are changing too. As a result the index of 1995 is not the same as the index of 2008. One must be careful from drawing too many conclusions from the data. It is good to analyse the data and have a perspective, but dangerous to make invest decision based on it alone. It easy to say the index is overvalued if the PE is above 30 or undervalued if it drops below 10. However it is not easy to arrive at a firm conclusion if the PE is 15 or 18 or similar such levels.

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I am not planning to make any forecast on where the forecast will be in the next few month. However I have done some analysis on the sensex and nifty index and uploaded it in the google groups. You can check here to download the file Quantitative calculation 2008.xls and check the first worksheet – market valuation.

The numbers for june 2008 are computed for both the sensex and the nifty. A few observations

1. The current PE for the sensex is around 16.8 and 17.7 for nifty. By historical standard ( history is few years back, not a few months) it is not too low. Just about towards the upper end of the PE band

2. The Return on equity (earnings/book) is still pretty high by historical standard. In the 90’s the numbers were generally low in 14-19% range. The last 3-4 years were actually an exception. We had a confluence of positive factors. Low interest rates, high demand growth and high capacity utilization all resulted in high returns. Companies had also re-structured and so net margins and ROE have been high in the past few years. The business cycle may be turning, with interest rates and inflation creeping up. We could revert to an average ROE of 18% (still higher by historical standards)

3. The Earnings growth has been 20%+ in the last few years. This has slowed down to around 10-12% in the current year.

Lets do some scenario analysis. For sake of assumption lets look at some probable scenarios on factors which are based on fundamentals

Book value is around 3540. An ROE of 18% which looks like a fair no. (look at the data for the entire 90s till 2003. I am still assuming a higher number). So normalized earnings is around 640 Rs which is lower than the current number of 820. What this means the earnings growth could slow down over the next few years as ROE reverts to the historical numbers. It is important to remember that ROE, unlike PE is not driven by market pschology. So the historical numbers do count in case of ROE.

For PE looks at the years 96-98. Interest rates were high and market PE ranged between 14-17.

Now for a juicy forecast – lets say earnings grow to around 900 in 2 years (book value will have to grow by 20% per annum and returns will drop to around 18% for that, so it is not impossible) and the PE is around 16-18, we are looking at a range of 14500- 16500.

Keep in mind that the assumptions in arriving at these numbers are still optimistic. We are still assuming reasonable growth in book values, moderate drop in ROE and fairly decent multiples. If things turn out better then we could have another bull market. But if we revert to historical levels, even on some variables such as ROE or PE or growth, then even the current market level is not too low.

Ofcourse other than the data, everything else in this post is a hypothesis. So my guess is as good as yours.

For an analysis of the index 2.5 years back see here