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Market looks set for correction as Sensex, Nifty PE ratios enter danger zone

However, the market rally could fizzle out soon and investors would be seen running for cover to minimize losses in the next few trading sessions, since Sensex and Nifty are trading at uncomfortably high price to earnings ratio.

Aseem Thapliyal        Last Updated: May 27, 2019  | 14:48 IST
Market looks set for correction as Sensex, Nifty PE ratios enter danger zone

Indian markets hit all-time highs last week after results of Lok Sabha polls indicated PM Narendra Modi-led NDA government looked set to return to power with a thumping majority. Investors are elated over the Modi rally which made them richer by Rs 6.32 lakh crore in the last six sessions before announcement of Lok Sabha election results on May 23.

The mood is buoyant across the market with prospects of a stable government led by PM Narendra Modi ensuring continuity of economic reforms.

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On Thursday, Sensex crossed 40,000 mark for the first time ever with index hitting an intra day high of 40,124 level after PM Narendra Modi-led NDA government looked set to return to power with a thumping majority.  On May 23, PE ratio of Sensex stood at 28.35 .                

Nifty too zoomed past the key 12,000 mark for the first time ever touching an intra day high of 12,041.  PE ratio of Nifty on May 23 stood at 29.02.

However, the market rally could fizzle out soon and investors would be seen running for cover to minimize losses in the next few trading sessions, since Sensex and Nifty are trading at uncomfortably high price to earnings ratio.

PE ratio implies the amount an investor is willing to pay to earn one rupee as profit. For example, if PE ratio of a firm is 25 it means that investors are willing to pay Rs 25 for Rs 1 profit the company earns. Similarly, if the PE ratio for Nifty stands at 23, investors are willing to pay Rs 23 for one rupee profit collective earned by all companies that comprise the Nifty index.

Generally, one should be cautious while investing in stocks when market's PE valuations are above 22.  When they rise above 28, markets are said to be in an overbought and risky zone.

Abhijeet Bajpai, Co-founder & CEO at Avighna Trades said, "It's a big win for BJP and the markets are relieved that the economic policies will not divert in any contradictory manner because of new government. NDA's win was largely factored in by the markets and the actual result in general is not a big surprise. Now the results are out it may not largely affect the markets as a whole. Investors and traders must wait for correction to enter in the market as going forward. Sensex and Nifty may need to consolidate at lower levels. In general, the market is expected to follow global market sentiments for next couple of days. Nifty and Sensex may correct about 5% in next few days. Investors must focus on quality midcaps in infra, financial and banking sectors during any correction in the markets."

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Nifty hit the PE multiple of 29.48, a 19-year high level on May 20 this year. Historically, high PE levels above 28 have led to correction in markets. High PE ratio occurs when an index rises at a faster pace than earnings which does not reflect the true picture of the market.

Nifty traded around the 12,000 mark on Thursday which left its trailing price to earnings multiples hovering at 29.02, an unproportionately high value which indicates Indian markets are in an overbought territory.

VK Vijayakumar, chief investment strategist at Geojit said, "At present levels of Sensex and Nifty, valuations are indeed high; in fact higher than in 2007. But the big difference is that this year (FY 2020) earnings will rise by 20 percent, of which half will come from corporate banks. So going by FY 20 earnings, PE ratio is not in bubble territory, but certainly expensive.

Beyond Sensex level of 40,000, valuations will be hard to justify. Correction can set in. It is possible that all the good news will be in the price by May 23."

Nifty had hit a PE of 29.39 in June 2000. On June 30, 2000, PE for Nifty stood at 29.39. It lost 40% of its value to 17.49 in June 2001. Nifty too followed suit with a 364 points fall for the same period. On June 30, 2000, Nifty stood at 1,471 level. A year later, the index had lost nearly 364 points to 1,107 level.

Similarly, on August 27 2018, PE ratio of Nifty stood at 28.72.  The PE ratio lost 15% of its value to 24.12 till October 26 in the same year. On August 27 last year, the index's value stood at 11,691 level.

During the next three months, the index lost 1,661 points to 10,030 level on October 26.

On January 4, 2008 too, Nifty PE (28.23) had risen above the 28 mark after which the 50 pack index cracked 56% in nearly 11 months. On January 4 2008, the index stood at 6,274 level.  It fell over 56% to 2752 on 27 November 2008.

Modi wave sweeps market: Sensex crosses 40,000 for first time ever, Nifty breaches 12,000

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