Prashanth Krish | Portfolio Yoga

CNX Small Cap Index PE – Running Rogue?

Price Earnings Ratio is something I believe is an important number and the PE ratio for Index has a way of showing where we are and based on past data what can be expected (with a reasonable probability of success) in the forthcoming months / year.

Consequently I use Nifty PE (while Sensex PE has a much longer history, its now not available for Free). The other day a friend on twitter asked me whether I was tracking the Small Cap Index. Curiosity sake, I downloaded the same and was stumped on finding it showing moves that even a micro cap will not show.

Do look at the weekly chart of the Small Cap Index

It’s one thing to expect gaps in historical data when you are checking out a stock. But this is worse since the gaps are on both sides and worse, day to day changes are some times so huge so as to make little sense as to what changed.

For example, the Small Cap PE rose from 24.17 to 49.34 one fine day in September 2012. The change in Index on same day (0.8%). On 16th Jan 2013, PE fell by 20% even as the Index fell by 1.5%. Another 20% fall in the PE was noticed on 1st April 2013 whereas the Index that day actually climbed 2.2%

In March and July of 2013, we once again saw 2 bumps up of nearly 20% on the PE Index even as the Index itself remained more or less flat on those days.

And then we had the mother of all rises as the PE index jumped from 50.17 to 162.83 on 28th March 2014. The Index on the same occasion rose by just 2.1%

On 7th April, the Index went up by 15.5%, went down the same percentage on 5th May and made a pole vault as it jumped 48.5% on 12th May. Of course, since after jumping up the pole, the next way is down,, PE dropped by 46.8% on 19th May. 22nd saw the PE Index jump by 20% and yesterday, another 10% rise.

Since the whole thing made little sense to me, I wrote to India Index Services & Products Limited regarding the huge gaps and today they were kind enough to reply to my mail with the following reply

I understand that as stocks are added and deleted, PE does change. But the kind of change one has seen in the small cap Index makes the whole work of tracking valuation pretty worthless. I mean which Index (other than maybe Zimbabwe) has PE valuations of 296 and this is not a single stock Index but a Index comprising 100 stocks.

Unlike say the CNX IT Index where Infy alone contributes to more than 50% of the weight (the top 3 in sum contribute nearly 85% of the weight making the rest of the stocks just showpieces whose movements will have no significant moves in the Index), here the Top 10 in total contribute just 17% which signifies that the spread is good (Link)

As of now, we do not have a ETF tracking small cap’s, but I believe that as the financial markets mature, we should see a lot more ETF’s than those currently in operation and when that happens, this kind of data blows away any analysis that maybe used with good results elsewhere.

Nifty Performance vs. PE Ratio

One of the key numbers I look at regularly is the PE ratio of Nifty to have a idea as to the valuation Nifty currently commands and whether markets are cheap, expensive or neither of the two.

For quite some time now (since mid 2011 to be precise), Nifty PE ratio has been moving around its long term average. Only once did we see a major dip which brought the PE to its 1 Standard Deviation on the lower side.

As on date, the current rise has meant that we are closing in on the 1 Standard Deviation on the upper band though even that is bit far away. But what is interesting is how does the PE compare to the return of Nifty.

Since 2008 low, Nifty has appreciated by 150%, Nifty PE has appreciated by just 85%. But more interesting is the way this has been accomplished. Lets first take a look at the chart;

After the markets bottomed out around October 2008, we witnessed a steady recovery post the bottoming of the Dow in March 2009. But even as the markets were dipping in the first couple of months of 2009, PE was already starting to move higher indicating the impact of bad results which were pushing up the valuation of Nifty even as Nifty itself did nothing.

This can be seen till the early part of 2011. Nifty doubled from the lows, the PE out performed it (in essence markets became pretty expensive in a very short span of time). To get a handle on how expensive Nifty was, do note that the high point was above the 2 standard deviation (which was seen earlier in 2008).

But from that point on wards, things have changed tremendously. Markets started to outperform the valuations (in other words, even as markets went up, quality of earnings meant that valuation wise, markets were still cheap).

I believe that unless we have another major global meltdown, this gap will only increase further. In hind-sight, markets seem to have been a buy on dips since early 2011. Question though is, is that strategy still a valid one? I for one believe so.

Does low volume days say anything

As usual, idea for this particular test has been borrowed from this blog post (Link)

I wanted to check whether there was any such change when the same was applied to Indian Markets. I used CNX Nifty and the Volumes are the total market volumes. While I have used close as entry price since that was the same used in the above test, Next day open is the ideal way to test since one cannot know whether today was a low volume day or not during the market hours.

But then again, such test would have been warranted if the results showed something significant. As the chart below showcases, no strategy can be build around low volume days since there is just no correlation between low correlation days and how markets behave over the next few days.

The Profit / Loss is in terms of Points gained (1 Nifty Unit being the trade size). Profits were not compounded and no transaction charges applied.

The left out feeling

Its been a pretty long time since we saw a move in the markets where dogs, cats and bananas are all rallying together, may with incredible speed that seems to suggest that even the gravitational force of Jupiter may not be enough to reign it in. For guys who have shifted their focus to selective trading / investments, this is a time where holding the nerves calm is a tough ask.

After all, even taking into account the strong showing of BJP in the polls, Nifty if up by just 8% for the month. On the other hand, stocks have done wonders. But how true is that fact?

A few days ago I analyzed the performance of stocks and came up with the following static

While its easy to assume that stocks have rallied across the board, the above data tells us that not everything has gone bonkers. Many stocks have horror of horrors under-performed even as both Mid and Small Cap indices have beaten the large cap indices by a pretty good margin.

What the left out feeling does is make us react in ways we believe we are trained not to react. In other words, while we assume that our thought process is pretty different from the herd, we actually start thinking and behaving like the herd. It takes a lot of effort (mentally speaking) to be able to remain calm and continue to follow the process we have laid out even as the rest of the market seems to suggest that we are barking at the wrong tree.

In 1999, when the tech boom was under-way in US, the one guy who decided to skip investing into any stock was Warren Buffett. As stocks continued to rally, it was seemingly obvious that he may have started to lose touch with the market. But 2000 showed why his famous quote (which he said in Feb 2008) makes so much sense.

But then again, a guy who one can contrast Buffett would be George Soros who has actually delivered a much strong return for his investors. While Buffett chose not to participate in bubbles and instead arguing for value based investing, Soros has once in the past said that while Gold seemed to be in bubble territory, he would be happy to be long as long as the trend was strong. But then again, Soros being Soros was able to get out of Gold well before it started to tank against say John Paulson who made money on the way up only to let go of a lot on the way down.

The reason I brought in Buffett and Soros was to show the diametrically different ways they dwelt with a situation. Both have prospered due to the fact that they both are good at what they do and rarely do go outside their area of competence (think about Soros buying Good Companies or Buffett shorting Euro / Pound).

A interesting adage in the markets goes like this

Bulls Make Money, Bears Make Money, Pigs Get Slaughtered

The retail participant is generally seen as the Pigs / Sheep as the probability of them making money on the long term is pretty low. But that doesn’t dissuade anyone since they believe they are better prepared than the guys who lose the race. Unfortunately, rarely does it turn out to be true (and this despite many of them spending a fortune in attending courses on how to make money in markets, buying tips / newsletters among others).

As Ed Seykota once said

Win or lose, everybody gets what they want out of the market

If you are feeling left out in the current rally, step back for a moment and think about whether you have a plan, a process to ensure that you can make it out if the cows start to come home (and many eventually will). Without a plan, you are a duck out of water – matter of time before you are shot and curried.

Do remember, markets were we were born and shall remain after we are dead, but if we mess us in markets, it can screw up a lot more things in life than just finances.

Are markets still worth buying into?

The current surge in prices has placed me in a quandry as to whether its still a good time to invest in the markets. While Infrastructure Index is up by 20.6% this month alone, we still are way way below compared to the glorious heights that was reached in 2007. Same is the case with a lot of other sectors as well, Realty, Metals PSU Banking Sector being the top dogs that have performed brilliantly in the current month while still being far away from their all time highs.

I believe that we may be entering a new stage in terms of how markets move from here. On one hand, there is huge amount of hope in the market with regard to the prowess of Modi. This has been the key reason for us to see such a rally even before Modi has assumed power as the Prime Minister of India. On the other hand, Modi is not P.C.Sorcar and over exuberance is sure to meet a gory end – not because he cannot deliver what he promises, but because the market just has run way ahead of valuations and all the low hanging fruit may have already been eaten away.

FII’s have been one of the key drivers in the market and in fact have been on a buying spree for quite some time. It was hence a surprise to see them turn bearish (though the amount is piddly) today. On one hand, this may be one of the off days, but on the other, this may also be the start of a profit booking season which if history is any guide does not bode well for markets.

In one of my previous write-ups on Nifty, I showcased as to how Nifty was nowhere near the top as in previous occasions, Nifty has topped out when the small cap index starting to beat the broader index black and blue. On that thought, do take a look at the chart below

The small cap Index has really taken off in the recent times and I wonder whether we may have (or may) see a peak for the short to medium term. On the long term though, the trend is yet to exhaust as can been seen in the chart below (longer time frame)

The above chart was discussed by me in early march in this post http://prash454.wordpress.com/2014/03/12/nifty-are-we-in-a-bubble-nearing-a-peak/ and the difference in returns since the time of writing that post is stark. Its interesting to note that despite the sharp rally we haven seen in the last few days, Mid and Small cap Indices are still bit off from the Nifty in terms of returns and only when they start exceeding the returns generated by Nifty should one start taking measures to lower the exposure to markets.

That said, the markets never behave / move in the direction vastly anticipated and what worries me most is the bullish stance taken by almost all broking houses. Below is a list of such targets I was forwarded on WhatsApp

* CIMB Raises Nifty target to 8,150
* BofA-ML raises Sensex target to 27,000
* BNP Paribas raises Sensex target to 28,000
* Citi raises Sensex Dec target to 26,300
* Macquarie raises Nifty target to 8,400
* Deutsche Bank raises Sensex target to 28,000
* CLSA raises India weightage by 2%
* Nomura raises Sensex target to 27,200
* UBS raises Nifty Dec target to 8,000
* ICICI Securities sets Nifty target of 8,100
* Religare raises Sensex target to 27,000
* Goldman Sachs Raises Nifty target to 8,300

For the life of me, I cannot remember when was the last time when we saw every broking house being so bullish about the future. And if every one is a buyer, we either should see a unprecedented boom (somewhat like what we saw in the 2nd half of 2007) or maybe we can take a break here before the next phase of the rally starts.

Either way, I believe that for now the future does look good. As long as one picks companies that won’t go bust anytime soon and avoids leverage (unless you have a full fledged trading system in place), the coming decade maybe the time to generate wealth on the scale one saw happen when markets relocated from 2003 to 2007.

Adios for now 🙂

Snake Oil Salesmen

In the last few days, mid and small cap stocks have virtually been on fire based on hope of a dramatically changed India. Stocks which were seen as having no future are going up as if its been virtually assured of a place in the heavens. Infra and Real Estate stocks which had been beaten down pretty badly are now up and running with a speed that maybe even Ussain Bolt cannot match.

Its one thing to expect companies that are performing good but have been bogged down due to overall slowdown in economy and credit crunch to try and reclaim their previous peaks and quite another to see companies, many of which are under Credit Restructuring mode to double or more. But then again, a rising tide lifts all boats. As Warren Buffet wonderfully put it and I quote

“A rising tide lifts all boats. It’s not until the tide goes out that you realize who’s swimming naked.”

The tide is rising and its carrying both good stocks and bad (bad doing in may ways much better than good stocks). While this would be a ideal time to unload from the portfolio the bad stocks, what usually happens is that good stocks are sold to buy bad stocks since good stocks do not move as much as bad and why have a portfolio that doesn’t move in such markets providing the right excuse to do the worst possible thing.

This also seems to be the time for both Paid and Free advisers to cherry pick their winners. After all, if one had recommended a well diversified set of stocks, it would be difficult to not have recommended some stock that has emerged a winner in recent times. Since I myself do not subscribe to any such services, I am in the dark as to whether they in addition to recommending a stock also recommend the portfolio weight or is it left to the discretion of the client concerned.

But unless the portfolio size is small (10 – 12 stocks?), its difficult to actually reap the rewards of picking a few winners since with a large portfolio (equally weighted), one’s investment is too small that returns, no matter how wonderful they are on the percentage scale, pale when calculated for the total portfolio.

In fact good friend Kiran tweeted as much today where he said (Link)

A company I know sells multiple newsletters with total portfolio size of nearly 100 stocks (max). Since the subscription is not expensive, I do believe that the number of subscriptions will be big. What I wonder though is, with such a large portfolio, how much can a investor hope to beat the market returns since the law of large numbers applies here as well as it applies elsewhere. While the risk of a strong hit to the portfolio due to one or two dud stocks is reduced to a very large extent, if a stock doubles in price, the swing it makes for the total portfolio is still just 1% which is negligible to say the least.

The biggest issue in my opinion with many of these stock advisors is the fact that their portfolio’s are high beta and strongly correlated to market. During good times, the returns are strong to make one not worry about the risk being taken, but as and when the tide turns around, easy to lose much more than what a simple index ETF would lose in the same period.

To me, stock markets are the only field (other than maybe Sports) where you really do not have to sell anything to make a living out of it. Using one skills is all that is required. Yet, this is a field that is filled with snake oil salesmen who clamor to help you in your goal to riches.

With there being no requirement of track record, no public audit of returns and very little interference from authorities, this is one field that seems immune to bear markets or bull. Claims of clients made X amount money after attending my 2 hour seminar / buying my newsletter is becoming common. I really wonder why the same guys need to sell their wares (products, what ever it may be), if making money was so easy. After all, all you need to do is press F1 (Buy) and sit while profits stream to your account. Why spent time writing mails on the great achievement their clients made and indirectly calling for newbies to come, learn and make big money.

The reason unfortunately is pretty simple. Very few actually make reasonable (in percentage terms) money trading the markets. Markets is a very harsh area where evidences seem to point out that survivor ratio (especially among the trading community) is less than 5%. Since traders / investors who lose money never fault themselves, they are easy feed for those who promise them untold riches only to be duped again and again.

Like any other professional activity, becoming a successful trader / investor requires one to be dedicate time and energy to the goal. Malcom Gladwell in his famous book Outliers talks about the fact that on an average, it takes about 10,000 hours of dedicated practise if one really wants to be successful. I wonder how many put in even 1000 hours before they decide that short cuts are the way to go (and 1000 hours of staring at the screen doesn’t count 🙂 )

I for one continue to believe that the best way to take advantage of the market for the vast majority of the population is via ETF’s and low cost mutual funds. No newsletter or tip giver will ever beat them on the long run (if they exist till then being the million dollar question).

And before I conclude, the following quote by Fred Schwed Jr in his Classic book “Where Are the Customers’ Yachts?”

“Speculation is an effort, probably unsuccessful, to turn a little money into a lot. Investment is an effort, which should be successful, to prevent a lot of money from becoming a little.”

Post Election thoughts

While Nifty did close positive, the very fact that we gained just about 100 points for a victory of the kind unseen since 1977 (non congress) does in a way reduce the enthusiasm about whether markets are really ready to take off or are we seeing a topping out formation.

On one hand, this move of today has a precedence in the way markets behaved on the day of results of 2004. Nifty closed with a small positive despite the fact that NDA which was seen as the front runner to the next government came up short and instead it was the Congress supported by the Left parties who were staking their claim to power. What happened in the next two days is history.

With the comprehensive victory for Modi, I believe most broking houses will start upgrading their targets for Sensex / Nifty on the back of optimism generated by the slogan of Modi “minimum government maximum governance”. In fact, UBS has already confirmed its target of 8000 for Nifty.

They key question is, Shall we see a run away rally? On the basis of evidence (some of which I shall present here), I guess not. But what I am sure off is the fact that this could be a turning point in the Indian Economy. The last such turning point in my opinion was the 1991 elections where P V Narasimha Rao took over the Premiership after India’s first experiment with coalition politics had brought the economy virtually to its knees. Over the next 5 months, Sensex rallied by around 29% (in hind-sight though, this was the led by Harshad Mehta). Since the markets never re-tested levels seen in the first few months of PVN, I believe that genuine progress in between (with economy being opened up) added up to the rise in markets and all of it were not due to the scam.

Where we do differ from 1991 is in terms of how cheap or expensive the markets were at that point of time. Right now, Nifty trailing PE (Standalone) is around 19.5 while Sensex PE when PVN took charge was 15.5. But since Indian economy was closed and we were growing at a much lower pace, this additional risk is not as big as it appears to be.

Small and Mid Cap index stocks are generally those having high beta and hence these stocks tend to ourperform the large cap indices. A look at the past data seems to suggest that markets tops have been accompanied by strong out-performance of Small Cap Index vs Nifty whereas at the current juncture, all Indices seem to be moving in tandem and there appears to be still some way to go before a major top is made.

Chart 1 – RS comparison of CNX Small Cap, CNX Mid Cap and CNX Nifty

Period: Jan 04 – Dec 07

Chart 2 – RS Comparison of the same indices for period Oct 2008 to November 2010

Chart 3 – the current stage. Time period starting from Jan 2012

In the second pane of the chart below, I have plotted the Net New Highs in NSE. This is a way to gauge the breadth of the market since if markets are moving higher with very few stocks making new yearly highs, its just a matter of time before such move collapses.

I have marked in a box the period from the election results of 2009 to the top we saw in late 2010. One can see the consistent nature of the new highs. On a similar nature, I believe that we are just seeing the start of a run up as its just recently that the Net New Highs has broken into positive territory.

In recent times, whenever India has seen a strong government at the center, markets in the next one year have given pretty good positive returns. The only times when this did not happen was in 1999 when NDA formed the government. The hitch if one were to say is the fact that we have been strongly out-performing the world markets (majority of them) in a big way even before the ink on the fingers (elections) were set.

During the last days, we saw the release of CPI for the month of April which came in at 8.59% and March IIP data which once again was in negative territory 0.5%. With Diesel prices being raised by 1.09 right after the elections got over, Inflation numbers over the coming months will not be easy to vanquish. This is seen by the strong yields in Government Bonds which despite the euphoria closed yesterday at 8.83%.

Below is a Nifty chart with the lower panel showing the number of days since the 200 MA was breached. As can be seen, we are nowhere close to new highs but at the same time, we are coming in close to the highs reached after the market topped out in 2010.

Another way to look at the above data would be to measure the % difference between the current price and 200 MA and the same is plotted in the chart below

Once again we can see that this rally is nowhere comparable to the ones we had seen earlier before markets topped out for the medium to long term despite Nifty trading at its all time highs.

Even in a bull market, markets do not go up in one straight action but is pretty choppy on the extreme short term. As can be seen in the chart below, Number of occasions when Nifty suffered a loss of 5% of more during the bull phase of 2003 – 2008 is much higher than the ones we have seen since 2010. In fact, we have seen more instances of 5% up over 2 days than 5% down over 2 days, but as the market evolves, look forward to more of them.

The Narendra Modi government that comes to power is coming with the highest expectation one has ever seen (since 1977 I assume) and that in itself can turn out to be a negative for markets since its not easy for even a guy who has showcased the development of Gujarat to turn around the story overnight.

At the same time, I believe that the next couple of years provide one the best opportunity to set up the foundation for what Rakesh Jhunjhunwala will call “The mother of all bull rallies”. As I sign off, here is me, hoping for the best 🙂

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