A reasonable amount of search has not led to even a half serious analysis of whether cyclically adjusting earnings and valuations may provide any interesting conclusions for investing in Indian equities. A recent research from CLSA tried, in my opinion unconvincingly and without much conviction, to do this across countries with a focus on Asia (including India) but the conclusion was that equities across the world were overvalued, making the case that Japan was on the cheap side (versus its own history but more expensive than India!) and if the numbers are to be believed we should go Greece (the lowest CAPE). The report also points out, inadvertently, a fallacy in this whole theory - that normalisation may not take out the 'abnormal' earnings of companies which may last over many years, exceeding what would 'normally' be considered a 'business cycle'. The other fact is how we have lived at least in the developed world, in an era of 'abnormally' low inflation. In fact, inflation is a very significant factor in variation of CAPEs that we have seen historically. The conclusion from CAPE that I draw is not whether equities are cheap or expensive based relative to history or relative to other countries but whether equities are giving good value for a certain level of inflation and for normalised level of earnings over a business cycle.
For a quick example, look at Prof. Shiller's own chart for the US, reproduced below:
The mean reverter in us will see and, of course, believe that US equities are overvalued. But this is not obvious from slightly deeper examination of the reasons. We have had historically low inflation and low bond yields, that is not reason enough to believe in the over-valuation of equities (Fed Model?). We have also had historically high corporate earnings (and mean reverters continue, quarter after quarter, to point this fact out) but is that a reason to dislike US equities? The period from 1981 to now, clearly shows a macroeconomic cycle change (prominently because of inflation levels) that makes any such mean reversion analysis performed in isolation, irrelevant. The 1980's bottom coincided with high inflation, similarly in the late 40's. The great depression and mini depression bottoms were of course, deflationary bottoms - hence, unclear (a look at real earnings is some help here). I leave the experts on US to continue to debate the future of equities there.
Back to India - A lack of earnings data of substantial length of time is one obvious reason for not having a detailed analysis here. The other - Inflation, which in the absence of (once again) longer term data makes for some difficult interpretation, but if looked at fundamentally proves very useful. Inflation, as we have seen in the US, is a reason why most market participants consistently misinterpret CAPE. Let's try and deal with these issues.
First, the cycle. I would like to use PE10 to show some consistency, but with issues questioning whether 10 years is a reasonable cycle, it is compelling to investigate some reasonable length of business cycle - something that gels well with GDP peaks and troughs as seen recently (stressing recently because macroeconomic management changed quite a bit starting 1991). In fact this does does makes good sense, considering the macro cycles in EM are more violent and shorter duration than developed markets where mechanisms exist to ensure stability. 4 years is an average cycle length in India - 2004, 2008, and possibly 2012 coincide with cyclical bottoms in GDP. 2000-01 was a dip too, but after rebounding, GDP fell sharply again in 2002.
Next, inflation. With the lack of good data on consumer inflation, I am inclined to Dr. Ajay Shah's (of NIPFP) preferred measure of measuring consumer inflation in India - CPI (Industrial Workers). This measure has been running above the Reserve Bank's comfort level now consistently for nearly 5 years, spiking to over 16% in early 2010 and now hovering around 9%. That is a significant level of inflation and it should have a strong impact on the CAPE.
Using the Nifty earnings as a base and the above assumptions, the CAPE chart for India is reproduced below:
The conclusions from this are obvious. Indian equities were clearly overvalued in early '08 but quickly moved to significantly undervalued by the end of '08. This happened in an environment where inflation continued to rise, but earnings declined sharply, though less sharply than the index.
Post 2009, Nifty price rise far exceeded rise in real earnings; inflation continued to be ignored by investors. While the average here is misleading, it appeared again in mid 2010, that as the index approached its all time highs, there was little support from real earnings. Since then, while real earnings have been stable, the index in real terms has continued to fall, leading to what seems now, an undervalued situation for Indian equities.
So if this situation presents a decent entry point, what can we expect and over what horizon? There are 2 paths here. The first is based on where inflation will go and the second, either as a consequence or in spite of inflation, is based on where earnings will go. Letting inflation run riot as it has in the past will continue to be disastrous for investor preference for equities and for the corporate cost curve. It will continue to put pressure on leveraged names which will find harder to finance themselves. If stern action on inflation is taken, demand will take an initial hit and earnings will stagnate. This is more true for India due to its inflexible labour laws where operating leverage will add significant downside to earnings and asset heavy companies will find financial leverage unserviceable. The environment clearly calls for a focus on companies that are restructuring their balance sheets and companies with low gearing or aiming to shed their heavy debt burdens will be preferred.
Whether voluntarily or not, persistent inflation will demand action and that is when broader equities will become extremely attractive. When that is visible to the market, it might already be too late to take advantage of good value in equities. Whether one believes in the added value of a CAPE analysis or not, Indian equities at this time are not only good long term value, but an investor with a horizon of a year or more will tend to benefit from a sensible exposure to this market, in spite of what challenges the global scenario poses.
For a quick example, look at Prof. Shiller's own chart for the US, reproduced below:
The mean reverter in us will see and, of course, believe that US equities are overvalued. But this is not obvious from slightly deeper examination of the reasons. We have had historically low inflation and low bond yields, that is not reason enough to believe in the over-valuation of equities (Fed Model?). We have also had historically high corporate earnings (and mean reverters continue, quarter after quarter, to point this fact out) but is that a reason to dislike US equities? The period from 1981 to now, clearly shows a macroeconomic cycle change (prominently because of inflation levels) that makes any such mean reversion analysis performed in isolation, irrelevant. The 1980's bottom coincided with high inflation, similarly in the late 40's. The great depression and mini depression bottoms were of course, deflationary bottoms - hence, unclear (a look at real earnings is some help here). I leave the experts on US to continue to debate the future of equities there.
Back to India - A lack of earnings data of substantial length of time is one obvious reason for not having a detailed analysis here. The other - Inflation, which in the absence of (once again) longer term data makes for some difficult interpretation, but if looked at fundamentally proves very useful. Inflation, as we have seen in the US, is a reason why most market participants consistently misinterpret CAPE. Let's try and deal with these issues.
First, the cycle. I would like to use PE10 to show some consistency, but with issues questioning whether 10 years is a reasonable cycle, it is compelling to investigate some reasonable length of business cycle - something that gels well with GDP peaks and troughs as seen recently (stressing recently because macroeconomic management changed quite a bit starting 1991). In fact this does does makes good sense, considering the macro cycles in EM are more violent and shorter duration than developed markets where mechanisms exist to ensure stability. 4 years is an average cycle length in India - 2004, 2008, and possibly 2012 coincide with cyclical bottoms in GDP. 2000-01 was a dip too, but after rebounding, GDP fell sharply again in 2002.
Next, inflation. With the lack of good data on consumer inflation, I am inclined to Dr. Ajay Shah's (of NIPFP) preferred measure of measuring consumer inflation in India - CPI (Industrial Workers). This measure has been running above the Reserve Bank's comfort level now consistently for nearly 5 years, spiking to over 16% in early 2010 and now hovering around 9%. That is a significant level of inflation and it should have a strong impact on the CAPE.
Using the Nifty earnings as a base and the above assumptions, the CAPE chart for India is reproduced below:
The conclusions from this are obvious. Indian equities were clearly overvalued in early '08 but quickly moved to significantly undervalued by the end of '08. This happened in an environment where inflation continued to rise, but earnings declined sharply, though less sharply than the index.
Post 2009, Nifty price rise far exceeded rise in real earnings; inflation continued to be ignored by investors. While the average here is misleading, it appeared again in mid 2010, that as the index approached its all time highs, there was little support from real earnings. Since then, while real earnings have been stable, the index in real terms has continued to fall, leading to what seems now, an undervalued situation for Indian equities.
So if this situation presents a decent entry point, what can we expect and over what horizon? There are 2 paths here. The first is based on where inflation will go and the second, either as a consequence or in spite of inflation, is based on where earnings will go. Letting inflation run riot as it has in the past will continue to be disastrous for investor preference for equities and for the corporate cost curve. It will continue to put pressure on leveraged names which will find harder to finance themselves. If stern action on inflation is taken, demand will take an initial hit and earnings will stagnate. This is more true for India due to its inflexible labour laws where operating leverage will add significant downside to earnings and asset heavy companies will find financial leverage unserviceable. The environment clearly calls for a focus on companies that are restructuring their balance sheets and companies with low gearing or aiming to shed their heavy debt burdens will be preferred.
Whether voluntarily or not, persistent inflation will demand action and that is when broader equities will become extremely attractive. When that is visible to the market, it might already be too late to take advantage of good value in equities. Whether one believes in the added value of a CAPE analysis or not, Indian equities at this time are not only good long term value, but an investor with a horizon of a year or more will tend to benefit from a sensible exposure to this market, in spite of what challenges the global scenario poses.
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