WHAT IS THE RIGHT LEVEL OF SENSEX TO INVEST IN STOCK MARKETS?

The most puzzling question for a lay investor is when to invest in the stock markets and when to exit them. The theory of looking at stock market indices to decide the time of investment was first taught to me by  Raghu Iyer, at SPJIMR, Mumbai when I did my MBA in Finance. But I did not probably believe in it so much. So, I observed and participated in the markets for two years even after I finished his module and then realized that there was a lot of sense in what Raghu postulated. I subsequently did a bit of my own research on the hypothesis and what I discovered, backed by some empirical evidence is what I shall discuss.

The biggest dilemma common investors, especially first timers and I am not talking about the traders who work on stop losses and triggers, face is when to enter or exit the markets or in simpler terms when to start buying and when to start selling. The answer does not require rocket science just common sense. Buy when markets are cheap and sell when they are dear. But how does a John or a Jane  Doe get to know, when are the markets cheap? Hmmm, that’s a bit tricky or is it? It is actually simple.

The Indian stock markets are anchored to two major indices the BSE Sensex (base 1978-79) and the Nifty (base 1990-1991).  For reasons of simplicity I shall base my hypothesis on the BSE Sensex which has a longer historical track record. The same should be applicable to Nifty also with minor variations.

The Sensex has a historic mean of 15.6x earnings and a modal mean of 14.4x  i.e to say that the arithmetic average is approx 15.6 but if we find the average based on the the number of times an incident occurs, then  the sensex trades more number of times at 14.4x annual earnings rather  than at 15.6x.

The first problem a common investor faces is where to find the earnings from? You can find it on the BSE or NSE website. Alternately, you can get it from The Economic Times or any pink paper. For FY 2011, the earnings were Rs 940/- So as I write, the markets are at 16121 level which translates into a PE multiple of 17.15. Is it not above the historical mean? Yes. But before we draw conclusions let me do a bit of math further. The Indian GDP in real terms is likely to grow at approx 7% in FY 2012-13. That means a nominal (real+inflation) growth of 14% in the Sensex earnings per share(EPS). Assuming the earnings also grow at the same rate, which is a very fair assumption, though bottomlines grow more than the real GDP numbers. The earnings of the sensex should be around Rs1100 in FY12.

In an efficient market the sensex should ideally stay at the mean. At an earnings of Rs 1100 for FY 2011-2012, the fair value of sensex should be  15.6×1100 i.e approx 17000 and equivalent Nifty levels of approx 5000. Are we there? No,  we are below it. It bodes well for a long term investor.

But the sensex will never be static at 17000 or so levels, all the time in an year. It is dynamic and the market moves as per the moods of the mob. And mobs are never rational. So, we have to buy or sell in an irrational market. The stock market becomes a place to buy good quality stocks only when the sensex is trading in a band which is less than the median Sensex PE. Prior to that, keep your money in Banks/FDs.Going by that premise, the markets have  given again a buy signal after Nov-Dec 2011 and are in a buy zone.

Statistically speaking, the standard deviation, represented by sigma,  of the sensex is 3.64. If I take the standard deviation of one sigma, it will give me a band of 11.96x earnings on the down side and 19.24x on the upside. As a lay investor, if I just track the sensex EPS and the sensex level, I should be able to know  whether the market is cheap or dear.  Below the historical mean of the sensex, any investor can safely buy any of the sensex stocks and then wait for the market vagaries to take the prices into the higher zone to sell. The buy zone starts below 16500 as things stand today. Ideally, the patient and long term investor should wait for the sensex to be available between sensex PE multiples of 1 and 2 sigma lower than historical mean. At the present moment it would mean a sensex between 13100 and 9150. Warren Buffet, the legendary investor invests 80-90% of his funds in times when the Dow Jones is 2 sigma below the mean and sits on cash at other times. From 2005 to 2008 Buffet did not invest in any company and just sat on billions of dollars of cash. Come 2008 and the Wall Street bubble of subprime burst and businesses like Goldman Sachs were going a begging. At that time Buffet deployed his cash by buying out Goldman Sachs. Similar were his investments in Washington Post and Coca Cola, a decade or so earlier.

The rational investor should start gradually investing 20% of his or her investible funds around a sensex level of 16,500 or below in instalments. At every 500 point downward correction in the sensex invest the next tranche of 20-30% of your funds. But if you wish to be a true value investor then you require truck loads of patience for the sensex to be available at a PE multiple 2 sigma lower than its mean because at that time one will have a huge “margin of safety”.  But such an occurrence may happen once or twice in a decade perhaps. As per statistics, if someone had followed this methodology, then in the past two decades the markets gave major buy signals in 1990, 1998-1999, 2003-2004 and 2008-2009 when the stocks were available at PE multiples within a band of  1? and 2? lower than the historical mean. An intelligent investor would have waited patiently for those opportunities and only invested his major funds during that period.

Will the market come to these levels in the near future? I can’t say because I am not a soothsayer. But at some juncture, the markets, when they are hit by a financial tsunami like a scam, a theme bubble, a sub prime crisis or a Grecian tragedy, they will be available at  (-)2? levels. And if it comes to those levels, this time I am going to bet my house on it, withdraw my entire PF and be greedy. For the time being, I am buying gradually into  my shopping list of good quality businesses available at cheap valuations.  For starters, look at Noida Toll Bridge Company, Piramal Health Care, Axis Bank, IL&FS Investment Managers, Yes Bank,  ONGC, GAIL and L&T. Buy them with a time frame of 3 years for reasonable returns and  10 years plus for real wealth to emerge. Most of them are debt free companies with very good free cash flows.