Why does the SENSEX at 63,000 means absolutely nothing?

The last week of June was when we again started believing in the power of equity to provide returns and reveled in the growth of the BSE SENSEX and the NIFTY and for the more aware with the equity markets, the Smallcap and Midcap indices too. Already we are toying with the idea of selling a large chunk of what we are holding and deferring whatever plans we have for buying.

And that is a big mistake.

On an absolute basis the numbers indicating the health of either the Sensex or the Nifty means nothing. Let’s take the case of the Sensex (ignore the latest rise from 63,000 to 65,000) and keep the figure of 63,000 as our operative point, then we would have lost the rise of 2000 points more. Furthermore, this level of 63000 odd has been touched as recently as December of last year and a couple of times before that too. However every time the index touched the magic 63k mark did we rush to redeem or did we hold back. If we redeemed then I am sure we are still sitting in cash but if we held on, the returns would have been more than attractive.

But to get back. Why is the number 63,000 or for that matter 65,000 meaningless as a pointer for the index? Simply because it is a static. Much like saying that another individual is richer than me. It gives me no idea of what either of our wealth is, what is the difference between the two, and who is growing at whatever rate and what is the spend rate. Even if I were to find out the absolute levels of our wealth, would it really signify anything substantial? What if my wealth is slightly lower but my expenses are way lower!! Or my dependents are much lesser than the other guy!!

Further on, for the last few times that the Sensex hit 63,000 or the Nifty north of 18,500, were the situation and health of the market the same or was it different?   Every time a new level is touched there is a different kind of euphoria but after having touched the higher levels more than a few times in the last 18 months, the mental high is of course not the same as the first time. Today we are already used to a 65,000 level as we have seen it already.

A better indicator of the equity indices – whichever one we choose to check- is the price to earnings ratio. Every company has a PE ratio and the index will have a weighted average of the PE ratio. If this remains in a comfortable band even at a high absolute level, then the level of the index is not high. If on a historical basis, we are at a lower PE level, than what it was sometime back at the same absolute level, then it can be surmised that the markets are positively biased for investments and vice versa. By way of an example if the PE at the last 63k mark was 22 and if it is at 20 now, even if the market levels are the same, it can be said that it is at a 10 percent lower level than the last time. This makes more sense as it takes into account the growth of the companies share prices and the profit numbers. This provides a better evaluation point for the health of the markets.

And further on, if we have the P/E/G number then we have a more enhanced indicator than the PE number. What it means is the PE number that we had earlier, needs to be divided by the growth rate, denoted as a percent. So if we have a SENSEX PE of 20 and the weighted average of the components companies are growing at a rate of 25 per cent, then the P/E/G is growing at 0.8. If the same was at a higher level when it touched the same number in the past, then the markets are cheaper than before. And the reverse applies too.

These are easily available data and any self respecting website which covers the equity markets will give you the details. Search a bit and you will find it. But don’t make the mistake of judging the health of the market by an absolute number.

Prasunjit Mukherjee