CAPE or Cyclically Adjusted Price-Earnings Ratio replicates the formula for Price-Earnings Ratio with the only differentiating factor being the denominator. Instead of a single year’s earnings, CAPE is estimated using average of 10 years earnings as denomination. This is done in order to ease out the volatility spikes of the market.
Is the stock market over-valued
Is the market over-valued? Analysts would answer this question differently using varied technical and fundamental indicators. Over several market sessions and cycles, it has been found that CAPE has been given a lot of reliance in terms of estimating the future versus the past. However, does it tell you the whole story or is it just a pattern discounting all other economic indicators and policies?
India Costliest Among All Markets
In 2013, the CAPE for Indian market was estimated for 2012 at 18.4 as against 17.2 in 2011, which were looking costly to the global market. Foreign investors had pulled out a lot of their investments which they had pumped in earlier. However, the market as a whole didn’t get beaten up in spite of such an action by FIIs. The market consolidated and gradually proved to have stabilized after three regressive years.
The last quarter of 2013 saw a lot of foreign players coming back to inject funds and gave it a good rally in patches. Based on the Cyclically Adjusted Price-Earnings Ratio in the previous five years, it was clear that among the Emerging Markets and BRIC nations, Indian market was the costliest. Several analysts were pro-active to highlight this fact based on historical data that there is a bubble and investors might be looking at yet another consolidation phase.
New Government – A Boon or A Bane?
However, another school of thought suggested that CAPE was just a number and doesn’t really govern the market dynamics holistically. The US and Euro crises in fact brought the best out of Indian market as investments kept flowing in and probably gave us the best possible year. With an impending election and a pro-NDA wave after a lengthy UPA rule, all eyes were set on the results throughout the last couple of quarters of 2013. A change was required by the domestic and foreign investors and the overall sentiments alone kept moving the market to new levels.
The CAPE numbers were estimated to 16.4 for 2013, which clearly reflects that expectations are to meet demand. The market overall doesn’t seem to be over-valued or under-valued at this stage. With the Budget being laid out to boost infrastructure, agriculture and manufacturing segment, it is evident that India is at a point, which can be termed as a neutral point to make fresh investments. Assuming that the present Government takes the right steps to ensure sustained growth and keeps the fiscal deficit levels under control, there is a great upside potential for stock investments.
A Lot to Gain or A Lot to Lose?
At the current levels, the Cyclically Adjusted Price-Earnings Ratio clearly encourages future investments as against 2012 when overall the market was highly volatile and moving in a high-beta mode. All that was required to be discounted has been taken into account. The Indian market has already made some expected progress this year during and after the election.
Based on the CAPE numbers over the past few years, several analysts have speculated that the SENSEX would trade on 90,000 points by 2020. Although it seems like a far-fetched scenario but given the optimistic forecasts for the future, nothing really seems impossible. Over the next two to three years, if sufficient development and growth initiatives are brought in place, the probability of markets touching the figure of 60,000 points to 75,000 points seems more realistic.
There is a fine line between technical indicators such as CAPE and fundamentals of the economy and the convergence of both can bring out the surprising element of human sentiments.