Investing during market highs: does it work for long-term investors?

Investing during market highs: does it work for long-term investors?

Investing at the market highs: does it work for long-term investors?

As the stock market climbs new highs and stock valuations reach record levels, fund managers and investment advisors are now suggesting that investors buy stocks at their highs rather than wait for a correction to make fresh investments. According to them, it pays off to ride the momentum during the rally and the investors run the risk of losing a profitable investment opportunity if they sit out the rally for long.

This turns the conventional investment strategy on its head where investors are advised to buy low and sell high. And this thumb rule is both for the stock price as well as its underlying valuation ratios. 

According to old wisdom, investors should accumulate a stock or an asset when it is really cheap. 

To put it simply, a stock becomes an investment candidate when its valuation falls below the long-term average ratios.

Also Read: 5 points to help you decide on investment in the stock market right now

Valuations beyond the comfort zone

The latest advice from Dalal Street comes at a time when more and more domestic investors are selling their equity mutual funds units taking advantage of the market rally rather than making fresh investments at current levels. Many analysts attribute this to investors’ discomfort about the record high stock valuations on the street now.

The broader market is currently 40-50 per cent expensive than previous highs. 

The benchmark Nifty 50 index was trading at an all-time high price to earnings (P/E) multiple of 39 times on Wednesday. For comparison, Nifty had peaked at P/E multiple of 29s during the dotcom boom in the year 2000 and 28x at the market peak in January 2008 respectively.

So should you really dump the old wisdom and buy stocks at the current level irrespective of their valuation? The straight answer is no. 

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You minimise your chances of making returns over the long term when you invest at the highs and take undue risks. 

Let me explain.

The fund managers are right when they say that the rally has a momentum of its own and the market can continue to make fresh new highs for months together. After all, we can define market peaks and bottom only with the benefit of hindsight. An investor in the second half of 2007 or early 2020 didn’t know that she was putting in money at the peak of a market. The investment decisions are always based on the latest information available and one tries to maximise gains and minimise downside risks over the investment horizon.

Buying cheap still pays

The market history, however, suggests that investors maximise the returns in their portfolio when they buy stocks while they are trading at a lower price to earnings multiple –a key measure of stock valuation and vice-versa. 

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There is a strong negative correlation between 5-year returns and the P/E multiple at the time of investment. 

For the Nifty 50 index, the correlation coefficient between P/E at the time of investment and 5-year returns is -0.73. This means a steady decline in returns for investors as market valuation (at the time of investment) rises.

This negative correlation between returns and valuation comes out clearly in the scatter plot shown below. Here we have plotted the 5-year return for an investor in the Nifty and the index trailing price to earnings multiple at the time of investment.

The plot suggests that the returns are maximum when Nifty P/E has been 15x or lower at the time of investment. Conversely, the five-year returns are in low single digits P/E is 20x or higher at the time of investment

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Also the five-year returns were next to zero for those investors who entered the market at the peak of the dotcom boom in early 2000 or the second half of 2007.

Readers should note that the analysis is based on the Nifty’s month-end value and trailing P/E beginning January 1999. The latest data is for December 31, 2020.

Market getting expensive with time

A similar negative correlation comes out in Nifty time-series data which is plotted in the chart below. The best period to invest in the equity market was between 2002 to 2005 when index P/E averaged around 15x. An investor who invested in this period made annualised returns of 25 percent on average over the next five years. In contrast, those who entered the market in 2006 and 2006 – when P/E was closer to 20x – earned just 10.6 per cent annualised returns on their portfolio over the next 5 years.

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A similar correlation has been playing out in the post-Lehman crisis period though the returns have been lower compared to what investors made before 2008. Moreover, the price to earnings multiple has been moving up each year, raising the downside risks for investors.

For example, those who invested in the market in the second half of 2014 and 2015 when Nifty was trading with a P/E of around 20x made 6 per cent returns over the next five years.

Conclusion

The broader market and the index may indeed scale fresh new high in the coming weeks giving handsome returns to the traders and investors in the short-term.

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The historical data, however, suggests that it’s best to enter the market when valuations are lower than the long-term average.

Nifty currently is around 50 percent higher than its five-year average earnings multiple of 26x. Any fresh investment in equity at current levels comes with undue risks and the chances of low single-digit annualised returns over the next five years.

The current market is good for momentum trade but a poor place for a buy and hold strategy.

(Karan Deo Sharma is a Mumbai-based finance and equity markets specialist).

Also Read: 5 steps to rebalance your investment portfolio in 2021

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