Long-haul investors play a heroic supporting role in the stock market

As reported by Mint, the latter were far worse. Both those scary episodes saw the NSE Nifty-50 index fall so much that more than double the investor wealth was wiped out—as a fraction of the total—than in the five months from October to February. And while those price slides left investors edgy, both eventually turned out to be perfect points of market entry. 

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A long view, thus, would urge people to stay invested. However, since we face other kinds of headwinds now and mustn’t simply extrapolate the past to the future, whether the market has ‘sobered up’ requires us to check if prices that went too high are reasonable again.

As companies and their prospects differ, what their shares are worth is a matter of subjective evaluation. Standard financial yardsticks, though, can still be used for comparisons.

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A handy way to judge a price is to divide it by annual earnings-per-share. This is its price-earnings (PE) ratio—or what a share costs for every rupee the company earns. The lower it is, the cheaper. But there is no rule on what ratio makes a good buy. 

The share price of a startup with no earnings, for example, would not even have a ratio, but its price could still be justified by the future profits it’s expected to rake in. And a firm with steep profit growth will have a larger PE ratio than others, as its market price would take its prospective upswell in earnings into account. So individual stocks can have varied PE ratios that are all seen to reflect fair prices.

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This yardstick gets especially useful if we look at PE trends averaged out across equities and time, as these reveal if they are trading higher or lower than usual. The PE ratio of all shares that compose the BSE Sensex ended last month a bit above 20 on a trailing basis (using past earnings data). 

This ratio was below its 10-year rolling average of 23.6 at the end of February, implying that Sensex stocks are now cheaper than their decadal trend shorn of short-term spikes. This suggests that these shares are oversold and their prices ought to recover on the back of earnings. 

A similar case can be made for other large-cap equities. But then, the 10-year moving average of the Sensex PE has also been rising. When covid struck, it was a tad above 20. Was its uptrend over the past half decade justified?

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Our economy’s robust recovery from the pandemic would justify it if corporate earnings have attained a sustainably higher growth path. Unfortunately, evidence of this has weakened lately. 

Even so, a rolling-average uptrend can also be supported by a lengthening investment horizon among investors. After all, a PE number can be interpreted as a count of how many years it would take for a share to earn the money invested in it if earnings stay constant (with profit expansion drawing that ‘payback point’ closer). 

So, if an index’s overall PE multiple is on a long incline, it may reflect growing investor patience too, not just rising prospects and/or asset inflation (overpriced stocks, i.e.). The actual mix depends on the ratio in which prices were driven up by long-haul buyers, earning trackers and quick-buck seekers. 

All said, the case for a market revival in the near-term may rest on patient capital to a significant extent.