Nowadays, in the world of people with high hopes and aspirations, where booms and busts are commonplaces, investors are willing to switch to anything which can be better as well as can generate higher returns.
At what price should you enter the market? What can be the lowest value of an asset? ‘At what value and how should the asset be priced?' These are the questions which investors search day and night. Nifty P/E is the most commonly used but mis-understood concept.
To introduce the topic, let’s first understand the basic movement of price, which is through demand and supply forces prevailing in the market. The demand for an asset increases its price whereas the excess supply decreases its price. In simple terms, asset pricing is the amount paid to acquire an asset. This price is the value which is assigned to the market, fairly or unfairly.
THE WAVE OF CYCLIC TRENDS
If you look for wise advice on the internet, it will look like this – "The best time to enter or to exit the market is when re-rating and the de-rating cycle starts". The concept is simple, the uptrend cycle of an asset is known as re-rating and on the other hand, the downtrend cycle is known as de-rating. The aim is to find the boom & bust cycles in the market and to further take positions of under or overvalued assets that are being traded in the primary or secondary market.
Investors always look for “better opportunities” and try to catch the bottom and peak of the asset’s price existing in the market, which the game is all about.
‘The catch is to find the peaks and bottoms, wherein the trend of the asset’s price changes.’
But is it so easy to find the bottom loops and come out of the peak falls??
Returns and losses are always made in extreme situations. The asset’s price in this situation creates fear and hype which consequently results in the disoriented state of understanding and investor may settle for any price of the asset and hence can go awfully wrong in the investment decision. This unrest in investor's mind forces them to ride on their sentiments and hence take detrimental positions in the market which can make their finances bleed for a long time.
THE BIG QUESTION IS “WHERE TO INVEST”??
Let’s get deeper and understand more about the relation between money market and capital market. Bond yields are key measures for comparing the asset prices. Government bonds are the safest as they cannot logically default ever. Therefore, the assets are priced from these bond yields. Ideally, investors will always go for higher returns if the two assets carry the same level of risk.
People will always take on less risky government bond investments if they will carry relatively higher returns as they are the safest assets. The assets pricing is based on fundamental value and returns generated on it.
Institutional investors like pension, PPF, Insurance companies, sovereign wealth funds constantly need returns for their massive investments. If other fixed investment options are giving less returns they are forced to move into more risky assets like equities, real estate etc.
The two biggest investment markets on the earth are the fixed income market and the equity market, so investments move in and out of them.
TO CHOOSE BETWEEN FIXED INCOME AND EQUITY INVESTMENTS
If bond yields are less attractive, the stock prices will shoot up and on the other hand if bond yields rise investors will switch to them as they are the safest among all available investments. Institutional investors always use ratios to calculate the price of the assets.
PE ratio is the most crucial element used in value investing. But you must have wondered what it is!!!!
The PE ratio is the amount paid to earn a single rupee on an investment. If the PE ratio of any investment is 22 then our return on this type of investment would come out to be 4.54% per annum. And on the other hand, for a fixed deposit if the interest paid is 6% per annum then the PE ratio of such an investment is 16.66.
Generally, PE ratios of shares are higher than bonds because of the growth prospects of earnings inherent in equity investments. But sometimes when the pricing of equity becomes overheated there are corrections. We at Mudraksh would like to shed some light on such critical turning points.
The graph below shows the trend reversals with ratios and nifty prices over the period of last 9 years.
Catching the Re-rating and de-rating cycles should be the aim as it acts as a trend reversal. Right time entry and exit can play an important role in building up the returns as well as it will be beneficial in avoiding loss traps.
The year 2018, from the beginning, is at a perilous valuation but now the formation of dipping point has been initiated. The market is at its highest peak and that will lead to the commencement of de-rating cycle.
So, brace yourself for the upcoming downtrend!
Recommended Read:– The Capital Asset Pricing Model: an Overview