If Sensex is going to fall then should we avoid stocks?

Since we have claimed that Sensex is over-priced, should the investor avoid stocks and equity investments altogether? Does this appy to mutual fund investments and unit-linked insurance plans (ULIPs) too?

We are not advocating a complete avoidance of stocks and we will rarely advise that. What we are suggesting is that tread with caution. Learn more about the companies that seem exciting. Of course, the exciting companies or glamor stocks are usually very good and fast-growth companies. But are they worth investing in?

Now that might seem like a strange question. If the growth stocks are very good companies then where is the question of "are they worth investng in?"? Well as it applies to anything that you buy, the question applies to buying companies or their stocks too. Is it worth buying? Or has the marke already priced it such that even if they remain as high growth as they promise to they might still not make any returns for the investor?

When markets are emphatically bullish about certain growth stocks their price sometimes has already factored in all future growth potential. If that is the case, then the only way for the stock to go is down even though the company might do extremely well.

So our advice is that try to do a fundamental analysis of the stock and try to understand if the market is already overpricing it way beyond its value. If that is the case, then please refrain from investing in it. Unless, of course, you are a momentum investor or technical trader or know exactly what you are doing and why...

Since we don't subscribe to greater fool theory we can only ask you to compare price and value.

Standard, Non-Standard & other Disclaimers

Before we go further, we should first of all clear up that investing is a very personal thing and the amount of money that you invest, where you invest, what returns you should expect and what risks are suitable for you depends a lot on case to case basis.

We clearly want you to understand that any decisions that you take should depend on your personal understanding of investment and you should seek professional advise from professional advisers if you want to make any investment decisions.

We are trying to provide the best information that we can and it is our personal belief that it might be better than most other expert advisers. However, it is your responsibility to select the appropriate advisers or take appropriate investment decisions suitable for you.

Following advise here might be injurious to your financial health.

Sensex is going to fall!

In the past two postings we have clearly indicated that the Sensex and the overall market of Indian stocks is overvalued. We can confidently say that the market is due for a fall.

However, as discussed by Alan Greenspan (then Chairman of the Federal Reserve Board, US) in 1997-98 in his briefing to the US Congress the stock market is showing "irrational exuberance". We could modify it slightly to portray the precise nature to "mis-rational exuberance".

The fact is that the Indian Economy is on a long-term high-growth rate path. However, that is going to happen over the next 50 years or so. However, given the India Shining echoes that are resonating across the globe everyone is reinforcing everyone else's optimism and we are discounting the 50 year growth path right now.

The economy will definitely grow at a huge rate. It will probably be 8% to even 10% on average for the next 25 years at least. However, will it be 8% every year for the next 25 years? Will all the companies in Sensex and BSE 200 etc. grow every year at the rate of 15% or higher for the next 25 years. Of course not. N

Some companies will falter. When that happens the investors will lose. Since at current prices the market has discounted all possible future growth for more companies. SO even if the economy and the companies grow as projected it will still not make any money for the investors. If the economy does not grow or the companies falter in thier growth the investors are going to lose big.

In our opinion and also some sane analysis earlier by others (http://www.equitymaster.com/DETAIL.ASP?story=1&date=3/30/2005) where they predicted Sensex to cross 10000 sometime in 2009. So what has happened is that the India Growth Story has been overhyped and what should have happened sometime in 2009 has happened 3 years too soon. Given that Sensex is now probably going to cross 12000 within this year, we are probably way into the future. Will be going back to future in 2009?...

Sensex or NonSensex? Part II: Is the Indian Stockmarket Overvalued

We considered whether the Indian stock market, or rather its indicator-the Sensex, was overvalued or not in the last posting. In this posting we continue looking at other indications that could throw light upon the value of Sensex and the Bombay Stock Exchange.

Since any investor has the option to either invest in equities or bonds or numerous other instruments it makes sense to compare the current yields of these instruments to find the more attractive investment avenues. Consider the Govertment security bonds (G-Secs).

These bonds could be termed riskless investment options since they are backed by the Government of India. The current yield for these bonds is about 7.4%. So if this is the riskless rate of return, how much is the yield of equities?

There are two kinds of yields when we discuss equity instruments. One is the dividend yield and the other is the earnings yield. The dividend yield on Sensex today is definitely way below 2%!

Earnings yield on Sensex is also in the range of 5% or less. For most stocks on Sensex it is in the range of 1.3% to 3.3%! And note that stocks are definitely more risky than Government Securities. So how and why are these stocks considered as attractive investments as compared to G-Secs?

The answer is that G-Secs will continue providing the coupons that are promised on them till maturity and the principal on maturity. Whereas, the Stocks can appreciate in value and provide higher earnings next year and years after that. If that happens then the earnings yields would improve and also if the stock price goes up then the "maturity value" of the principal would also increase.

(Of course, we understand the above description might not be too kosher for the veteran investor, but that is an easy way to compare stocks and bonds.)

In any case, it seems that given the positive outlook a case is being made out to invest in stocks even when the current yield is not even half or in some case one-fourth of what can be obtained risk-free on G-Secs. Normally, stocks should provide higher yield as compared to bonds since there is a risk premium required from stocks which are inherently riskier as compared to bonds.

As we have demonstrated above, we think the huge differential between the yields of bonds and stocks is another indication that the Indian Stock market and specially the Sensex and other leading indices are overvalued by a huge amount.

Clearly, we expect a correction. We ask the investor to tread with caution. There are opportunities for the mature investor but the beginner should be very very careful in his selection of particular stocks or even investing in mutual funds.