Shyamal Banerjee/Mint
Shyamal Banerjee/Mint

They say the Sensex will touch 40,000. Will it?

Watch the value of the market rather than punt about its levels

They’re saying that the Sensex will touch 12,000?" She said in a hushed whisper. It is 2005 and I am talking to a senior citizen couple who have come as guests to get their financial plan made in my first television show called Show Me the Money with NDTV. I remember being unhappy with their 100% stock allocation at a time when their had unmet lifestyle costs. I had wanted a rejig of the portfolio towards some regular income products while leaving at least half the portfolio in stocks. But the thought that the markets will keep rising kept them from doing anything about their portfolio. The next decade saw the same index soar to just over 20,000 in January 2008, then drop like a stone in water to just over 8,000, 14 months later in March 2009. The Sensex is flying at almost 25,000 now and the question remains the same, with just a change in value. “They say the Sensex will go to 40,000 soon; will it?"

My answer remains the same—don’t watch the index; it tells you almost nothing. At its very simplest, a stock market index is an average reflection of the prices of 30 or 50 or 100 or 500 stocks. Looking at the index level to invest or sell is uneducated because the information that an index value carries has very little to do with what the future holds. Rising or falling stock market indices simply tell you the direction of the mood in a stock market. To understand this better, let’s look at the price of a single stock. The price of the stock, too, has no information in it to predict the future—it is simply the price somebody is paying for one share to somebody who is selling that one share. Very simplistically, when there are more buyers than sellers, the price begins to rise. How high it will rise depends (again very simplistically) on the value of the share. Which brings us to the question: why does a share have a value at all? Isn’t it a punt where speculators make it go up and down? Speculators may affect share prices in the short term, but the overall direction of prices depends on the ‘value’ of the share.

When you buy a share in a company you are agreeing to take the risk the entrepreneur takes to the extent of your holding in that company. Therefore, it is called ‘share’. You share her risk. If you bought the company’s bonds, you would get a predictable return every year. But when you ‘share’ the risk, both the upside and the downside are much larger.

As an investor, you are hoping that the company you have funded (in however infinitesimal manner) will make profits at an increasing rate. If it makes 1 crore this year, it will make 1.5 crore the next year and 3 crore the year after, and so on. As an investor, you can see your share of profits as earning per share and the company also declares dividend from the profits. If the total number of shares is 100 and the company makes a net profit of 10,000, your one share has ‘earned’ 100 (assume you bought the share for 10). But you don’t get this money in your hand. Now suppose your friend wants to buy your share. Will you sell for 10, or 100, or more?

More, right? Because you think that next year, the profit will be 20,000, taking your share of the profit to 200. If you sell at 200, then the ‘valuation’ (price-earnings) of your share is 200 (price) divided by 100 (earning per share), or 2. This means your friend is buying your share knowing that at the current level of profit, it will take him two years to recoup his investment. But she buys at twice the current value hoping for an uptick in profit.

Now expand this example to all the stocks in the index. The absolute value of the index has no information in it for the future direction. The valuation of the index does give a pointer. The current ‘discounting’ or price divided by earning per share of the Sensex is near to its 10-year historical average of 17.8. If prices keep rising without the earnings growing, the market will ‘correct’ and come back to a more reasonable level. But if the earnings grow, there is room for prices to keep rising.

Do you see why markets are up? In the expectation of India being open for business again after a 10-year period of a reversal to the 1970s business-is-bad philosophy. This will eventually translate into profits and earnings growth, which will reflect on the market. So if you really have to watch something, watch the ‘value’ of the market and the prospects of India coming out of the current growth decline rather than punt about stock market levels.

Monika Halan works in the area of financial literacy and financial intermediation policy and is a certified financial planner. She is editor, Mint Money, Yale World Fellow 2011 and on the board of FPSB India. She can be reached at expenseaccount@livemint.com

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