Is it a bubble?

One of the hallmarks of a bubble is that it’s most easily detected after it has popped. Part of this is because there’s a certain logic to high prices at the time.

I have borrowed the above lines from a blog post I read today. I really liked this superb line from this blog post.

Very often, the investors want to know answer to this question in advance. However, very few have been able to correctly predict it and even fewer have been able to repeat the feat.

This is what I wrote in the book on this subject:

Attendee at a seminar: “There are bubbles in the market every now and then. What are the indicators of the next bubble?”

Expert speaker: “The day you stop thinking of this question, that is an indication of the next bubble.”

Enjoy while it lasts.

#RidingTheRollerCoaster –

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Timing the market or buying cheap?

A few days ago, we wrote a blog post Timing the market …. I got a call from a friend, Priyesh Sampat, who read the post and had a question. He asked about a certain strategy adopted by some financial advisors, which changes the allocation between equity and debt based on the P/E ratio (or P/BV ratio) of the market. Even some fund houses have schemes that change the allocation between equity and debt based on certain valuation parameters.

I did not refer to such a strategy, which I would call tactical asset allocation strategy based on market valuations. Market timing generally means getting completely out of a scheme or an asset category based on a negative view. In case of tactical allocation, one would change the allocation but not reduce the same to zero.

Here is an excerpt from the book that talks about the relation between valuation at the beginning and the next five year returns:

Stock markets have enormous amounts of data and hence we decided to take an example from that market. We have taken the PE ratio as an indicator of valuation and the Nifty Total Return Index as a proxy for the equity asset class.

The PE ratio is derived by dividing the current market price of a share by the profit per share of the company. Since both these are mentioned on a per share basis, one can also calculate the PE ratio by dividing the company’s market capitalization by the profit generated by the company. The higher the ratio, the more costly the share; and lower the ratio, the cheaper the share.

The PE ratio is a function of too many parameters in case of a company and hence it is very difficult to generalize the above line while comparing two different companies. At the same time, when we are looking at a broader (diversified) index, the PE ratio could act as an indicator of valuation of the overall market or a segment of the same. Over the last two decades, since the inception of the National Stock Exchange, the PE ratio for the index has moved between roughly 9 at the bottom to 29 at the top.

The Nifty Total Return Index (TRI) is constructed using the same composition as the CNX Nifty Index, with the dividends paid by the companies reinvested in the index. Thus, the Nifty TRI could be helpful to calculate the total returns generated by the index – the sum of both the change in the index value plus the dividends thereof.

Below is a graph of the 5-year return from the Nifty TRI against the Nifty PE ratio at the start of the investment period.

PE ration vs future returns

(Source: Nifty TRI and Nifty PE ratio data from www.nseindia.com)

It is clear from the above chart that investments made at lower valuations have generally delivered higher returns. However, if the investments have been made at high PE ratios, the future returns have been lower.

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Valuations in the new era

In 1934, the great investment theorist Benjamin Graham wrote of the pre-1929 stock bubble:

Instead of judging the market price by established standards of value, the new era based its standards of value upon the market price. Hence, all upper limits disappeared, not only upon the price at which a stock could sell, but even upon the price at which it would deserve to sell. This fantastic reasoning actually led to the purchase for investment at $100 per share of common stocks earning $2.50 per share. The identical reasoning would support the purchase of these same shares at $200, at $1,000, or at any conceivable price.

(Source: Four Pillars of Investing – Lessons for building a winning portfolio by William Bernstein)

William Bernstein writes further in “Four Pillars of Investing”, “Even the most casual investor will see the parallels of Graham’s world with the recent tech/Internet bubble. Graham’s $100 stock sold at 40 times its $2.50 earnings. At the height of the 2000 bubble, most of the big-name tech favorites, like Cisco, EMC and Yahoo! Sold at much more than 100 times earnings. And, of course, almost all of the dot-coms went bankrupt without ever having had a cent of earnings.

To see a similar pattern across time periods, across geographies and across asset categories, read the chapter on “Valuation” in the book “Riding The Roller Coaster – Lessons from financial market cycles we repeatedly forget”. There were cases of such ridiculous valuations in real estate stocks in India in 2007-08, real estate prices in Japan in the 1980s, tulip bulbs in Amsterdam, technology companies in the 1999-2000 – such events have occurred at an amazingly high frequency.

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Sir John Templeton’s investments in Japan

Sir John Templeton was known as a global bargain hunter. He loved to spot opportunities across the world when majority of the investors invested within their own countries.

One of his major investments was in the Japanese stocks, when it was out of fashion to do so. He invested in Japan in early 1970s, much before the world saw any reason to do so.

Many Japanese conglomerates had cross-holdings, which the market could not put a value on. Sir John started loading up on stocks of some great companies, which were valued at single-digit PE ratios.

By the time the world got interested in Japanese stocks, the stock prices as well as the PE ratios had gone up a lot. Sir John Templeton had started to withdraw. Much before the peak of the market in 1989, he was completely out of Japanese stocks.

A true contrarian, a true value-investor.

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Crazy valuations

At the peak of the market craze in the late 1980’s, the PE ratio of the Tokyo Stock Exchange Index, TOPIX, was above 100

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