Why D-Street needs caution when 1-year estimated PE nears 18

For investors wanting to understand market peaks, the one-year estimated Price to Earnings (PE) ratio would be a good measure to track. Historically, whenever the one-year forward PE ratio of MSCI India index crossed 18 times, the market has mostly corrected in the ensuing periods, according to a Goldman Sachs study. For instance, the MSCI India has fallen 9 per cent in a year after the forward PE ratio crossed 18 times.

Early this month, the Nifty and MSCI Index were trading at a 12-month forward price-to-earnings ratio of 20 times, nearly 15 per cent higher than three years’ average. India’s stock benchmarks — Sensex and Nifty — have corrected 4 per cent each in the last seven trading sessions.

PE ratio is a widely watched valuation measure. A rising PE ratio means valuations of the index or the stock too are moving up. Market participants have been wary about the market prospects because of elevated valuations and challenges to the economy. “PE derating is likely for overall markets, in our view, as current one-year forward PE for Nifty (18x) is near historical highs and off earnings likely to be cut 7-8 per cent,” said Gautam Chhaochharia, head of India research, UBS. “10y G-Sec and earnings yield gap, at a historical high, is unsustainable.”