Roughly the 5% fall in a week has shaken up lot of investors. Most of the people, who were being prudent and telling that stick to your asset allocations, are now getting call that “when you knew market is overpriced, why did you advise to invest in equity and not stay in Debt.” Let me know one of the known investor in India market Vijay Kedia “Only two people can predict the top & bottom of the market; God & a Liar“. For last few quarters, I have been telling all my people to respect their asset allocation as well as that markets are overpriced so stay vigilant and do not invest a lot in markets. I was getting calls to tell that see market is touching new highs and you are missing the profit opportunity. Now i am getting the similar reactions but reverse that why did i not push them to stay in fixed returns vs equity if i knew markets were overpriced. I wrote about P/E ranges to show the trend over last 18-20 years and how to use it (Read), also i spoke about how much equity you should hold is dependent on 4 parameters as Risk Appetite, Risk Capacity, Time Horizon & Market Valuations. Today, i will try to redeem myself and other investment enthusiast from such blames.

Can i interpret the market move for tomorrow or 3 months or 6 months? Answer is simple no. Can i comment on current scenario probably yes. It is similar to driving, If i am driving from Mumbai to Goa, Can i say how fast i will drive constantly? No, it depends on the traffic but during the journey based on the parameters like congestion, traffic signals etc i can say reasonable speed limits. Similarly looking at high P/E ratios i can not say that market is going to correct and stay out or market will grow faster invest more. Mathematically P/E just the ratio of two variables but in reality it is driven by whole lot of variables like investor sentiments, macro economic scenario, liquidity conditions, international markets, economic growth cycle etc. Still let’s stick to maths as it helps you simplify the complex things. The movement of P/E value has only three possible scenarios;

  1. The value of P/E increases, if the growth of price is faster than the growth of the earnings. If price is flat and earnings are decreasing (-ve growth) then also the P/E will increase or if the price is growing at +20% and earning are growing slowly at +10%
  2. The value of P/E is range bound, If the growth of price is similar to the growth of earnings. It can be either both are moving at +20% or both are falling at -10%. P/E value will still be similar
  3. The value of P/E decreases, When the growth of earning is faster than the growth of price. Earnings might grow at +20% which prices are growing at +10% or Earnings might stay flat while prices are falling by -10%

Since P/E in absolute terms do not tell us anything for concrete, why are we looking at it. let me tell you the words of the dean of value investing, “In the short run, market is like a voting machine, tallying up which firms are popular and unpopular. But in long run, The market is like weighing machine, assessing the substance of company.“So in all three circumstances One can not predict that what will be return in next few weeks, months, quarters or years. The only thing that can be said that P/E will try to move towards the theoretical value.

Let’s address the main question, what should we do? My boring suggestions as below:

  1. If the prices are increasing but earnings growth is slow or flat or negative, it is not a very healthy market and P/E will increase above the mean value. You will see price correction if the earning growth faster than price growth do not come by. It is best to invest slightly less in markets during such scenarios compared to your ideal asset allocation
  2. If you see the prices has been flat to decreasing and you see the earning growth coming or staying intact then you should opt to increase your allocation to equities compared to your usual asset allocation
  3. In all other scenarios stay with your own asset allocation

Those who are looking for thumb rules, let me share the updated P/E chart to follow as thumb rule.

PE Range as of Oct 05, 2018

Read more on Mutual Funds & Investment Planning, Happy Investing!!