Stock markets are at an all-time high and the P/E ratio is very chose to 24 (much higher than the usual average of 18). The question that is on the minds of many investors is “what should long term investors do in this market?”
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We used data for last 16 years for this analysis (4,000 days of market data). We wanted to look at the relation between the movement of Index, P/E ratio, and the returns generated by an investor who is investing in the Index on a regular basis and holding it to date.
Observations from the chart:
- Index direction has been distinctly north bound but for few blips along the way (this is consistent with the trends seen in other markets as Index is a decent proxy for wealth in the country.)
- P/E for a large part has been in the 15 to 25 range with rare periods where it was out of this range.
- Index return has predominantly been between 10% and 20%, with an average around 16.5%. Index return has been a bit higher after 2013, this can be explained by the limited passage of time and can be reasonably expected to move towards the long term average.
- Index return has been below 10% only for a very few days in the last 16 years.
- Index returns have been low when the P/E has been high and vice versa.
Historically average P/E for Indian market has been 18 and ranged between 10 and 30. For this analysis we have organized P/E into 5 groups, 10-14, 14-18, 18-22, 22-26, and 26-30.
From this one can conclude
- It is best to invest when the market P/E is low.
- It is possible that P/E can stay high for sustained periods of time (like in 2010)
- It is very difficult to predict how and when the P/E will correct.
- It may not be prudent to make investments when the P/E is over 26.
- If one holds for a long time the returns from investments made even during high P/E will be reasonable.
- If one is investing steadily over a period of time then one is able to invest at various levels of P/E and generate returns that are closer to the average return in the market.
From this one can conclude
- One can reasonably expect returns of over 8% over the long term for equities.
- One should expect variation in returns over a period of time.
- If one has a disciplined approach to investing and invests regularly over a long period of time then one can expect to get returns in various buckets and the average can be closer to the long term average.
A review of returns using both P/E and CAGR bucketing:
In the final analysis the following can be a reasonable strategy for investors:
- Investor’s expectations of returns from the market should be aligned with the historical averages that have been realized at the similar P/E levels in the past.
- People who have investment opportunities that can reasonably generate over 10.5% returns on a post-tax basis should be cautious when investing in markets where the P/E is over 22.
- People who have investment opportunities that can reasonably generate over 8% in returns on a post-tax basis should be cautious when investing in markets where the P/E is over 26.
- Long term investors who are investing in equities should
- Ensure that investments being made when P/E is over 22 have a minimum of a 3 year horizon and preferably a 5 year horizon to provide a margin of safety.
- If the market P/E is over 26:
- Index investing is best avoided at this level, investing in direct equity should be done only if there is enough margin of safety
- One should consider selling securities that have poor fundamentals
- One should be very cautious before completely exiting all equity positions especially ones that are reasonably valued. If the correction of P/E is by increase of earnings (as seen post 2009) then one may not be able to find a reasonable entry point.
- People who believe that they can time the market by exiting at the top and re-enter at the bottom may want to be cautious as there is no evidence that this can be done and the opportunity cost may be too high if the market corrects by an increase in earnings.
- People holding a significant portfolio (with about 20% of their total assets invested in equities) and have seen a significant run up should be open to holding for long term and accepting a bit of rationalization of the prices. Trying to hold-on to the profits that resulted due to a temporary market mispricing by selling and purchasing may prove to be counterproductive.
- Long term investors who are investing periodically and have plans to continue to invest over a 3 year horizon can continue with their investment plans. The overall impact of the investments during the high P/E period may not significantly impact the long run returns.
Disclaimer: The information provided here is based on our opinions plus our statistical and financial data and independent research. The article does not constitute individual investment advice and is not intended to be a solicitation for investment advisory services. Authors do not guarantee any results that may be following the strategy discussed above. Readers should note that investing involves risk and they should not make any investment decision without first consulting his or her own personal financial advisor and conducting his or her own research and due diligence.
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