Is the market nearing bubble zone?

After two days of mild correction, bulls on Dalal Street are back in business with the markets soaring again. However, with each progressive rise
in benchmark indices, the market appears to be close to the bubble zone. Based on Wednesday’s closing price, the NSE Nifty Index is now trading at a price to earning multiple of nearly 23.

This is just a notch below the all time Price Earnings (PE) multiple of close to 28 witnessed at the peak of the previous stock market booms in early 2000 and late 2008. Could this be history repeating itself?

This should not come as a surprise to old timers on the Street. Financial markets have a tendency to oscillate around historical means. This is evident in the chart above where we have plotted Nifty movements during the last 10 years against corresponding ups and down in its price to earning multiples. As the chart shows, Indian equity markets have a history of hitting extremes in terms of valuations.

Currently, the Nifty is trading at close to 23 times that of earnings per share (based on the earnings of companies that comprise 50 stock Nifty) in the last four trailing quarters. This is around 25% higher than the Nifty 10-year average (median) valuations of around 16-17 times preceding year’s earnings. Only twice in the last 10 years has Nifty been more valuable and both these occasions — the dotcom boom of 2000 and the credit boom of late 2007 — turned out to be bubbles that burst. On six other occasions, which may be described as normal times, the market has faced a strong resistance at a P/E multiple of around 20 and corrected subsequently.

However, bulls never give up without a decent fight. In early 2004, the tussle between the bulls and the bear dragged on for nearly four months. Finally, bears had the upper hand and the market tanked by close to 30% and valuations were low enough to fuel accumulation that set the stage for a bull run. A similar duel was seen in late 2006 and early 2007.

At its peak in October 2006, the market’s PE multiple touched 22 when Nifty crossed 4200. The market is once again poised at a similar juncture. The PE multiple appears to be entering the bubble zone. There are only two outcomes from here — either the market corrects so that valuations are back to the historical averages, or bulls gain full control of the street and the valuations enter the bubble zone. While both outcomes are equally plausible, bulls will need some bit of help from the boardrooms of India Inc besides purchasing power (or liquidity).

Earnings growth need to pick up fast, otherwise the valuation will keep on getting dearer, pushing the market closer to the bubble zone. However, the earnings outlook is far from rosy. Earnings growth in the June 2009 quarter was driven by operational leverages in the form lower raw material and finance cost. This will run its course by the September 2009 quarter. After which the earnings growth will be driven by revenue (read demand) growth, which will be tougher to achieve.