What the PE ratio tells about market direction

By Ritesh Jain

The price earnings (P/E) ratio is one of the most widely used value indicators and quite prominently used by investors while investing. Stocks with low PE ratio are perceived as having cheaper current price, hence expected to generate higher return in the subsequent period. PE ratio is computed by dividing the market price with the company’s earning per share. The study of the historical trend in the PE ratio of the index gives useful information to investors on the attractiveness of the market.

Generally, there are two variations of the PE ratio; one being the Trailing PE ratio and the other being Forward PE ratio. The Trailing PE ratio uses the earnings of the last 12 months, while the Forward PE uses the expected earnings for the next 12 months. The Forward PE requires estimating the forward earnings and hence, is prone to estimation errors. Moreover, the same is not easily available, while the Trailing PE ratio is easily available on a real time basis.

SCENARIOS OF PE EXPANSION OR CONTRACTION When the Index rises at a faster pace than earnings, PE expands. Inversely, when the Index falls at a faster rate than the earnings contraction, it leads to a lower PE.
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STUDY OF SENSEX TRAILING PRICE EARNING RATIO We have done statistical analysis of movement in Sensex PE ratio for the last 16 years and have tried to estimate the likely returns based on regression analysis. The average trailing PE ratio of the Sensex has been in the region of ~18.6. While it touched a high of 29 during the dotcom bubble in 2000, it hit a low of 12 in 2008 during the sub-prime crisis. Based on the level of PE and subsequent index returns, we observe that the Index enters the overvalued zone at PE of above 21 and undervalued zone below 16 (which is roughly one standard deviation away from the historical average).

The current trailing PE at 18.8 is marginally higher than historical average, though it did come below 17 during the month of February 2016, before moving up. It is pertinent to note that the trailing PE has been in the region of 17 or below for about 30% of the time over the last 17 years.

REGRESSION ANALYSIS OF SENSEX PE & INDEX RETURNS As pointed out earlier, there is a strong relationship between the PE ratio and stock market returns. We ran a regression of Sensex returns based on historical PE Ratio. We compared the Sensex returns predicted by the regression analysis over 1, 2, 3 and 5 Years.

The regression of Sensex PE and the subsequent 2 year return gives the best fit. The R-Square, a measure of how well observed outcomes are replicated by the model is at 0.65, (the range for R-Square – highest 1 and lowest 0), indicating a fair amount of predictive power of the model.

CONCLUSION There is a strong correlation between the Trailing PE ratio and the Sensex returns and study of the same provides some useful insights into the stock market returns. Going by the historical data, and our statistical analysis, the Sensex delivers higher return whenever the trailing PE ratio moves below 17, and tends to deliver negative return whenever the same crosses 21. Investors can use this important indicator while taking decisions of entry or exit from the market.

(Ritesh Jain is CIO, Tata Asset Management)

DISCLAIMER: The views expressed in this article are personal in nature and in is no way trying to predict the markets or to time them. The views expressed are for information purpose only and do not construe to be any investment, legal or taxation advice. Any action taken by you on the basis of the information contained herein is your responsibility alone and Tata Asset Management will not be liable in any manner for the consequences of such action taken by you. Please consult your Financial/Investment Adviser before investing. The views expressed in this article may not reflect in the scheme portfolios of Tata Mutual Fund. Mutual Fund investments are subject to market risks, read all scheme related documents carefully.