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Is Winter Coming?

After years of anticipation, winter is finally coming. Never before have so many people across the wo
Is Winter Coming?
By Making smalltalk • Issue #12 • View online
After years of anticipation, winter is finally coming. Never before have so many people across the world eagerly awaited the arrival of any “season”.
The North isn’t the only place where cold, grey, and stormy clouds are lurking though. The bright & sunny air of Dalal Street, which is currently celebrating as flagship indices Sensex-30 and Nifty-50 hit all-time highs, may also face turbulent storms ahead.
While there are solid reasons behind the recent optimism displayed in the broad market, many fear the coming few months may be far less cheerful. A popular reason for this pessimistic view is the uncertainty brought by impending elections, but another indicator that has people bracing for market storms is the Index P/E.
Just yesterday on 2nd April, the P/E ratio of the Nifty-50 touched an all-time high of 29.24. Same for the Sensex-30. But why is that worrying? Like many other financial indicators, the P/E ratio gives an idea of when stock valuations are relatively cheap (i.e. when to buy) and when valuations are relatively high (i.e. when to sell). And the current Nifty-50 P/E indicates that the benchmark index is at its peak valuation compared to historical levels.
The Price-to-Earnings (P/E) ratio shows the amount one is willing to pay for a stock for every rupee it earns as profit, and is calculated by dividing the stock’s current market price by its earnings-per-share (EPS). For example, if the price of a stock is ₹100 and its EPS is ₹5, then the P/E multiple is 20. Finally, the Index P/E is the weighted-average P/E ratio of all the stocks currently in that index.
Generally speaking, a stock with a P/E higher than its peers is considered to be more expensive (since for the same level of earnings, one is paying relatively more for this stock). Interestingly, P/E ratios vary across industries:
  • capital intensive sectors like Oil & Gas or Metals usually have an average P/E of 8-12
  • P/E ratios in excess of 40 are quite normal & expected when it comes to industries like IT, FMCG, or banks.
It’s important to note that a high (low) P/E ratio doesn’t necessarily mean that a company is overvalued (undervalued) - it could mean the market already expects the company to do well (poorly) in the near future, expressing this expectation in the stock price. This usually readjusts when the next earnings is released by the company. As such, when looking at P/E ratios, it’s important to also check the historical trend and compare with peers.
The current P/E of benchmark indices are at unprecedented levels, and the first time index P/E ratios came close to such highs was before the 2008 financial crisis hit the Indian markets. On 8th Jan 2008, the Nifty-50 P/E reached its then all-time-high of 28.29 - and then a few months later in October 2008, it hit its all-time-low of 10.68! Since then the Nifty-50 P/E has breached 28 only over two short time periods in Jan 2018 & Aug 2018 - both times the Nifty-50 fell soon after its P/E hit this level, only to quickly recover in a few months.
Now there is no way to accurately predict what will happen this time - perhaps the markets will tank soon, perhaps they will remain range-bound, or perhaps there is a fundamental shift in the market and these high P/E ratios will slowly become the new normal. But just like spotting rare white ravens in Winterfell or finding direwolves south of the wall are signs that winter is coming, super-high P/E levels of market indices are usually a sign of upcoming market corrections.
While Ned Stark was ultimately right in predicting that winter is coming, believe it or not the world of stock markets is even more complex than the world of Game of Thrones. At current levels, the market deserves to be cautiously observed - but only time can tell whether this sign will lead to a Red Wedding or a royal feast in King’s Landing.

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