So, what are the markets telling us now.
Here’s the trend of the Nifty 200 PE (price to earnings) over the last several years
As you can notice, PE (one of the valuation metrics) is coming down.
Why are the valuations coming down?
Well, price to earnings is affected by two variables. The Earnings and the price.
Let’s say the earnings are not changing. In fact, they are going to continue to grow over the next few years (growing economy, favourable demographics, etc, etc).
Then the price should go up too, no?
Ideally. But in finance, price is determined through a nifty “time value of money” concept. We “discount” the future earnings at a given “interest rate” to see what’s the “present value” or the “price”.
You can read a simple explanation of time value (PV, FV) here.
When the interest rates were low, the discounting was less, price was high.
But, the interest rates are going up.
I think the following chart helps us see that.
At a higher interest rate, the discounting is bigger reducing the present value and thus the prices.
Why is the interest rate going up?
In response to the rising inflation, so that it can be curtailed. It’s the standard “central bank” response.
Increase in interest rates will hopefully drive demand down and thus contain prices/inflation.
Whether it will work and when it will work is a question mark.
What should you do as an investor?
I just wrote a small thread on twitter. It goes like this.
- This is a time in the markets when the investors who had only returns in mind, now have only risk in mind. The two are not separate.
- The right thing to do is to think risk first, returns will follow. But our minds are not tuned that way… “kitna deti hai” is always the first question.
- There is a simple rule based method to get this going. Asset allocation + rebalancing. Simple and very effective. That’s your neat trick for wealth creation.
The Asset Allocation indicator tells you this too.
What are you doing now?