A signal for markets?
A very good interview by IDFC MF Dy CEO says that most investors come in when the PE ratio for the markets are in the highest band ie between 19-25 times earnings and get little or no returns for next few years which makes them disillussioned with both markets and investing itself.
What the IDFC folks have done it is created a market signal much like a traffic signal with Red , Amber and Green signals ( these are valuations so the index number does not matter for example at 16000 points if the EPS for index is 1600 its dirt cheap and at 12000 points if the EPS for index is 600 the markets are very costly..so just reading the index level doesnt tell the full story)
Red signals PE of more then 19 meaning markets are richly valued and risks are high
Amber signals fair valuations at PE of >16>19
Green with less than 16 PE means markets are undervalued, they may be just undervalue at say 15 pe or highly overvalued at 12 pe.
Now a word of caution here markets simply dont fly from green to red offering a quick way to make money but sort of meander a long time at green and amber before suddenly shooting up which means that as usual patience pays. Also just because its in red zone doesnt mean you need to sell all your holdings because markets may be in red zone all the way from 19-25 thats almost a 30% range so they can go high and keep going higher too.
The main issue is that in green zone the valuations are low because mostly the news flow is negative, economy is slowing down, Inflation is high etc. These are not the times when investors generally prefer to buy but this is the only way to get good returns not when there is a slew of IPOs ,fund launches and everyone is painting a rosy picture.
Secondly green and amber zones are best for SIPs too as markets seems to stay in these zones a longer time frame than red zone which makes them ideal for accumulation.
The only hitch here is if the EPS of sensex keeps going down bringing the signal from green to amber to red without prices moving up, this remote possibility happens when earnings drop are significant but the good news is that while these can be bad for a single stock usually earnings of sensex are blended so well that chances of everything going wrong at same time is nil..even if it does like in 2008 markets fall rapidly and enter green zone again making the valuations attractive.
So an lay investor can use the PE ratio as a good valuation tool and entry point for both lumpsum purchase as well as SIPs to get superior returns. There are funds specifically designed that move from debt to equity or vice versa based on the PE ratios such as FT India PE ratio Fund of Fund, Principal Smart Equity Fund. FT India PE Fund for examples moves between Franklin Bluechip and Templeton India Income Fund based on the PE multiple being higher or lower and has given almost same returns as Franklin India Bluechip Fund over last 5 years with much less volatility.
The full interview by IDFC Dy CEO can be read here http://wealthforumezine.net/AMCSpeakIDFC091011.html