It’s about 10 years since Prof. Robert Shiller of Yale University published his seminal work Irrational Exuberance, a book which talked about the perversity of bullish analyst forecasts for earnings and the market.
Shiller wrote the book at the height of the dot com bubble and argued that markets were overvalued at that time. The bubble burst immediately thereafter, and Shiller turned from a university don to a market maven.
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One argument that Shiller adopted was the long-term indicator known as the cyclically adjusted price-earnings multiple, or CAPE. The common trailing price-earnings multiple is susceptible to be distorted by business cycles, argued Shiller.
Earnings can be elevated in a boom and depressed in a bust, thus not presenting a true picture of market value.
So, he developed the CAPE indicator, which averages 10 years of inflation-adjusted earnings to smooth out business cycles.
Now, Indian stocks are trading at an average of 23 times trailing earnings. This is much above the historical multiple of 18, and suggests that the market may well be overvalued.
What about the CAPE indicator?
Using the excel sheets provided by the excellent professor on his website, this column calculated the metric for the Sensex, using the consumer price index (industrial workers) data.
By that method, the Sensex price-earnings multiple is 26.7. This is again above its 10-year average of 24.8. For the BSE 100 index, the current price-earnings multiple is 22.82, while the CAPE is 25.8.
Now, overvaluation doesn’t tell you in which direction the market will move.
In the last bull run, when the Sensex’s CAPE crossed 27, it stayed there for nearly three years, moving to as high as 49.
However, if you believe, as Shiller does, that markets tend to revert to normal over the long term, this means that stock prices will grow at a slower pace than earnings.
In other words, future long-term returns may be below average.
Moreover, the current business cycle itself may be peaking.
With high commodity prices, demand-pull inflation pressures and consequently higher interest rates, earnings are likely to be under pressure in the near term.
Also, with the favourable base effect coming off, there is an increasing concern that earnings growth might disappoint.
Perhaps, that is why the markets shed 492 points, or nearly 2.5%, on Friday, the most in 16 months.
Graphic by Ahmed Raza Khan/ Mint
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