In Current Market Is There More risk than reward

In Current Market Is There More risk than reward



At current levels, long term investors can't gain without taking on substantial risk.


The PEG is a crude rule of thumb that equates expected earnings growth rates to equity prices. If the price to earnings (PE) of a stock is below the expected earnings growth rate (G) expressed as a percentage of current earnings, the stock is undervalued. Illustratively, if earnings are expected togrow at 20 per cent and the stock’s current PE ratio is 15, the stock is undervalued. At a PEG of 1, a stock is fairly valued. If, however, the PE ratio is higher than the growth rate, the stock is overvalued.

This analysis is hardly rigorous. The PEG is a reasonably good valuation tool because it mirrors investor expectations in that it links future expectations with prices. It’s also conveniently built around information that is easily available in the public domain.

Anybody buying a stock has presumably made an estimate of earnings growth; making such estimates is, in fact, the raison d’etre for equity analysts. Many companies also issue a quarter-to-quarter ‘guidance’ based on internal estimates–or on what they would like the market to believe. Their numbers are often flawed. In mathematical terms, it’s easier to predict the winning number in a lottery than it is to pin down the next quarter’s earnings exactly. Still, we don’t need exact numbers for PEG; if the estimates and ‘actuals’ are close, it’s good enough.

The caveat.


The PEG is also used to judge the valuation of the entire market. In theory, it’s a reasonable method. We calculate the average PE and the average estimated growth of the basket of stocks in an index and based on these numbers, work out the PEG of the index. In practice, things are much more uncertain. This is because one is dealing with averages; it takes only one stock with a tremendous growth rate (or losses) to skew an index’s growth expectations to unrealistic levels. And when one is dealing with the average of 30 or 50 stocks in a weighted index, naturally, the inexactitudes multiply.

Don’t get me wrong; I’m not dismissing the PEG. It is a useful benchmark. But it’s important to keep a greater margin for error when we use PEG to judge a market’s valuation rather than the valuation of a single stock.

At current prices, the Sensex trades at an average PE of 19 and average growth expectations for the Sensex basket would be 20-25 per cent for the financial year 2005-06. If we accept the lower end of the estimates, the Sensex is fairly valued; at the higher end, it’s undervalued.

By my admittedly pessimistic logic, growth is likely to be closer to the low end of that 20-25 per cent band for several reasons. One, the rupee’s rise because of which the IT sector–a key source of earnings growth–is downgrading earnings estimates. Two, rising domestic interest rates, which will hit financial services companies and manufacturers with large working capital requirements. Rising rates will also depress consumer demand.

Point of return.


Given all this, I would lean toward the conservative end of the estimates and suggest that the market is already fairly valued. This implies that there isn’t much room for safe investment in the near future.

Of course, this doesn’t mean that prices won’t rise from these levels. In fact, prices will rise further. We’re in the middle of a bull run and bull markets always peak at well above fair value estimates.

A trader can certainly ride this bullish trend and make money till such time the markets peak. Once the trend reverses, and prices start sliding, the trader can then hope to go short and make even more money. But for a long-term investor, there’s a point in a bull run beyond which he can’t gain while staying within the bounds of safety. It seems to me that point has already been reached. It’s now very difficult to find decent stocks at fair values–every good growth story seems to have been optimistically discounted.

If you’re tempted to trade, it may be worthwhile to concentrate on a few large, high-volume stocks. That way you can exit in the event of a crash. Don’t take inordinately large single positions. Don’t play with the housekeeping money or leverage to an extent where you are left with positions you can’t cover. And, note that trading is a fulltime game. You might have to quit your day job in order to keep track ofyour portfolio.


Happy Investing
Source:Outlookmoney