The commentary around market levels, the price of the index and its valuation, is getting even more confusing as benchmark indices scale new highs.
Some call out high valuations and are waiting for the index to correct. Others believe there is enough reason for indices to continue moving up.
For most individual investors making sense of all this, as well as the future direction based on the market or stock prices is a hard task. You can thank the many signals and the dynamic situation we are living in for this.
You don’t always need to get technical to judge whether valuations are high or low. Using some common-sense research can also give you a rough idea about the reality at the moment.
Using GDP as an indicator
Stock prices are a function of corporate profitability. If corporate profitability is increasing at an expected pace each year, then stock prices too, are likely to move up at an expected pace. A positive push to profitability implies that there is a chance that market prices head up faster than expected, and vice versa.
Analysing corporate profitability is not an easy task. The information is not always available to a layperson. As a proxy for this, you can use the annual and quarterly GDP figures as a proxy. If the GDP is steadily declining but benchmark indices continue to move up, check whether there is reason to believe that the downtrend in GDP is temporary.
If not, this mismatch is a red flag to watch out for.
If the GDP growth and equity market prices continue to move in opposite directions for a few quarters, the overvaluation of equity prices can’t be ruled out.
Interest rates as an indicator
When we talk about interest rates in conjunction with the equity markets, it’s not the bank savings rate account. Rather, we are referring to the benchmark rate in the economy or repo rate.
The rate at which banks lend to corporates is driven primarily by the Repo rate which the RBI fixes. Competitive market forces also play a role. During times when the Repo rate is trending lower, bank lending rates are also lower.
This in turn means that corporates can borrow at lower rates and reduce cost, thereby, increasing profitability. It also means that individuals can borrow at a lower rate, thereby increasing the surplus for saving or spending. All of the above are positive for stock prices, which tend to go up when interest rates are falling.
If stock prices go on increasing in a period when interest rates are high, it’s a red flag. This kind of rise in the stock market may lead to overvaluation.
Inflation as an indicator
Inflation refers to the price rise in an economy. It is assumed that in a growing economy a standard level of annual inflation or price rise is healthy. When demand gets overheated or there is too much supply of money, then inflation starts trending above average.
If inflation remains stubbornly high, goods and services start to become unaffordable for a vast section of citizens and consequently, demand starts to slow down.
Moreover, interest rates get hiked to cool off inflation. Both conditions do not bode well for corporate profitability.
If equity markets keep rising in the face of rapidly increasing or persistent above-average inflation, it is a valuation red flag to watch out for.
There could be times when more than one factor is at play and the signals from each are conflicting. The more persistent a factor is, the more lasting its impact is likely to be on equity valuations.
These are just quick thumb rules to judge equity valuations. However, note that timing your investments on the basis of valuation is fraught with risk and an overall better strategy would be to just continue regular investments throughout the year, based on your asset allocation.
If you do have a lump sum amount available to invest but are worried about market valuations being high then a Systematic Transfer Plan (STP) can help you out. Click here to learn how Scripbox can help you with an STP to work around market valuation as well as volatility challenges.