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The Chartist: What Next?

Long-term investors should increase index fund exposure when Nifty's PE is below 14

At the instant of writing (June 26), the Nifty is trading at around 2,925 points. The technical perspective is negative. May 11, 2006 saw an all-time high of 3,774, followed by a low of 2,595 on June 14. A short rally peaked out at 3,130, and was followed by another drop. A bearish pattern of lower highs has been established. This is yet to be confirmed by a pattern of lower lows but it would be reasonable to expect further bearishness, given lower tops, lower volumes and poor breadth.

How long is the trend likely to be negative? One way to seek timeframes is through the use of that familiar fundamental tool: The PE ratio.

We may note that the PE tends to oscillate within boundaries though prices can rise (or fall) indefinitely. Earnings may rise (fall) by indefinite amounts. Hence, the index may also rise/ fall indefinitely even if the PE discount does not change much.

Data on the Nifty PE is available since 1999. If we examine annual lows, the Nifty has generally bottomed below 14. It has tended to peak above PE 20. The lowest discount registered was about PE 11 (in September 2001). The highest PE was registered in February 2000 when the Nifty hit a high of 1818 points at a PE of 27.3. .

This helps us establish a rule-of-thumb. We can state with some confidence that the Nifty bottoms below 14 and a prudent long-term investor should be interested in increasing index fund exposure below Nifty 14. Similarly, a prudent investor should start cutting exposure at above Nifty 20. Incidentally, a fundamental investor would be fairly happy with the implied PE to growth ratio. Most of the time, the Nifty has traded close to a PEG of around 1.

Just for reference, the 2006 low of June 14 (2,595 points) was at a PE of 14.8. The May 2006 high came at a PE of 21.5. The current (June 26) PE is 16.7.

Let's assume that the Nifty PE will continue to oscillate between these rough boundaries of 14-20 and make a few future projections. First, we adjust for earnings growth. I'm assuming the Nifty EPS will have a CARG of about 15 per cent between 2006-2011. The historic CARG since 1999 is about 15.4 per cent so this is a conservative estimate. We can use these projections to establish the possible ranges within which the Nifty may wander over the next five years or so. If we assume that the market will stay bearish, the Nifty would still tend to rise over this period because the EPS would rise.

Our estimate is that, even in the event of a catastrophic bear-market where the Nifty stays at around 14 PE till 2011, the index would still hit the 5,000 level over five years. If the market turns bullish again, we could see prices in excess of 7,000 Nifty by 2011.

Conservatively, at 5,000 Nifty, an investor at current values receives about 11 per cent CARG. Optimistically, at 7000 Nifty, a current investor receives about 19 per cent CARG. This return excludes dividend payouts and re-investments. Even the lower bound of returns is quite impressive.

Obviously, these are crude linear projections. The Nifty EPS could show a fair amount of volatility over the years and the composition of the index may change. There could also be periods when the index trades down to 11 PE and it's quite possible that there will be tops at well above PE 20.

But the basic broad outlines of returns will remain the same if the Nifty EPS continues to grow at close to its historic CARG and market discounts don't change radically. Thus, if you buy index funds heavily at the current prices and every time the market trades close to 14PE or below that, you should receive long-term returns in the mid-teens at least. That's a pleasant prospect.