Nifty & Earnings

I have often heard and read statements such as “markets have gone ahead of fundamentals”, “the market has run ahead of earnings”, “earnings have yet to catch up” etc. but could not find/understand any statements that put it in numbers. This write up is an attempt to quantify Nifty growth vs its earnings growth and see if we can identify periods of excessive over optimism and pessimism. Please understand that this is not a holy grail and is just an attempt/idea and maybe a different angle to look from with respect to earnings

(Click charts to enlarge)

Chart 1

Data and Methodology:

All data is sourced from NSE. On chart 1, the left side represents the Nifty and its Earnings rebased/indexed to 100 since 1^st Jan’99. On the right side we have the spread of these indexed numbers expressed as a % of the indexed earnings to see if there is over optimism or pessimism in the price with respect to earnings. Calculation as per the below :

I am taking 1^st Jan’99 as the starting date and basing that to 100 for the Nifty and its Earnings value. 

Earnings = Nifty/PE ratio

On 3^rd July the Nifty closed at 8484.9 which is 9.525 times the value of 890.8 (1^st Jan’99) closing, hence on an indexed/rebased to 100 level the Nifty Indexed number comes to 952.5. Same methodology to calculate Earnings Indexed.

The last column, Indexed spread is calculated as (Nifty Indexed – Earnings Indexed)/ Earnings Indexed. i.e. (952.5-470.58)/470.58 and expressed as % terms.

Observations:

From chart 1 we can see that the indexed spread i.e. the red line above 100% is a sort of danger zone and readings above 120% have led to disastrous returns from that point on. As for bottoms, indexed spread readings in the 0-20% zone have been major bottom’s in markets. Unfortunately there is not much data history to see this across many cycles but I believe if you combine the above chart with a chart of basic P/E ratio and its standard deviation bands (chart 2 below) one can get a sense or double confirmation of an overheated market.

Currently the spread is at 102% and going by the above study and past instances, the returns have been meagre on a longer term timeframe when the spread is at or above 100%. But yeah the PE ratio has not yet hits its +2 SD band…

Chart 2