It's time to book profits in equity

The current rally would entice new investors to enter the market, but the valuations are expensive. Anyone who invests in a portfolio that mirrors the Sensex at current valuations can expect only about 10% annualised returns over the next five years

Karan Deo Sharma
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It's time to book profits in equity

It's time to book profits in equity

The bulls are back on Dalal Street and the benchmark indices have been touching fresh highs every day this week. The benchmark BSE Sensex is up 4 percent during December so far –one of the best monthly starts for the equity market in more than a year. Thanks to the rally, the index is now closing on the psychologically important mark of 70,000. With this, the index has rallied by 10 percent from its lows in October.

The rise in Indian equities is part of a global rally in equity indices as the yield on benchmark US 10-year treasury bonds has declined by 90 basis in the last one and half months on expectation of an earlier-than-expected rate cut by the US Federal Reserve. 

The yield on 10-year US treasuries is now down to 4.12 percent from a 52-week high of 5.02 percent made on October 23. A decline in US bond yields made investments in equity assets attractive for foreign investors and the month of November and December saw net investments by foreign portfolio investors after two months of selling.

The rally would be enticing for new investors to enter the market in the hope of making a quick buck. While no one can predict the short-term movement in the market, the rally is not conducive for long-term investors anymore. 

Existing investors should take advantage of the rally and book some profits in their portfolios. They can deploy the cash in safer assets such as bank FDs and wait for a correction for fresh investments in equities.

This is because the rally has begun to push up equity valuations in India. The Sensex trailing price-to-earnings multiple is now close to 25X, the highest in nearly two years, and is up 12 percent or 250 basis points from its lows in October this year. This is because corporate earnings in India are not keeping pace with the rise in stock prices.

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At its current level of valuation, the market has entered the expensive zone and historically there is a high negative correlation between market P/E at the time of investment and 5-year forward returns to investors. In the last two years, the Sensex trailing P/E has been in a range of 22X to 25X. The market has always bounced back from 22X and there has been a correction at the upper end of this range. The current valuation is closer to the upper end of this range which raises the downside risks for investors.

Buy low sell high

The market history however suggests that the investors maximise long-term returns when they invest in stocks at lower P/E multiples and vice versa. For Sensex, the correlation coefficient between P/E at the time of investment and 5-year CAGR returns is -0.51. This means a steady decline in capital returns over a five-year period as entry P/E gets higher.

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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 Sensex and the index trailing price to earnings multiple at the time of investment.

data to back sensex p/e
Sensex P/E and 5-year forward returns. Pic: 30Stades

According to the Sensex data for the last 20 years, the long-term returns for investors are best, when trailing a 12-month P/E multiple at the time of investment between 12X and 18X. The 5-year CAGR declines to single digits or at best low double digits when Sensex P/E at the time of investment is 20X or higher. At a trailing P/E of 25X or higher, 5-year CAGR returns in the last 20 years have ranged from -1.4 percent to 10 percent. 

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The five-year CAGR returns were next to zero for those investors who entered the market at the height of the dot-com boom in early 2000; in the second half of 2007 or at the next market peak in the latter half of 2010 or in the late 2014 and early 2015. Conversely, investors earned high double-digit returns whenever they invested after major corrections when valuation had been lower such as in 2001 to 2003, 2009 or 2012 or 2017.

If history is any guide then an investor who invests in a portfolio that mirrors the Sensex at the current valuation can expect around 10 percent annualised returns over the next five years, which is below par considering the risk involved in equities.

The analysis is based on the Sensex month-end value and trailing P/E beginning January 1998. The latest data is for November 2023.

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 could be a good place for momentum trade but it will punish investors who believe in buy and hold strategy.

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

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