Nifty@5650 !! Where to go from here ?

The confidence of investors in the Indian markets is at high again. From the lows of 4800 level in May 2010 the Nifty is now at 5650 i.e. 850 points in less than 6 months or around 18% rise. In the process Indian markets have outperformed every other major market in the world which are all down anywhere between 5-10% be it US or China.
FII confidence is also at all time high in the Indian markets so far this year we have received close to USD 13b investments. Barring May 2010 virtually every month we got on an average couple of billion USD FII money in to the Indian market.
The optimism in the Indian markets is mostly driven by two factors
1) High growth expectations ( 8% GDP growth)
2) Cheap money from the developed economies (In the name of stimulus)

Let us discuss about these two factors in a leter article and discuss about the valuation of Indian markets first and see where it can go now.

Note: Mostly I track Nifty and for this discussion is also based on the NIFTY index.

Historical Nifty Levels

Historically Nifty on an average for the last 10 years traded at an average PE 17-18 and above a PE of there is always a chance of deep correction to 15-16 PE (Average). In most of the cases the correction was to 13PE. Also on the other side a 12-13 PE on the Nifty is the safest time to invest time to invest with most of the time Nifty moving to 20PE after it on an average.

Below is a 10 year historical PE graph of Nifty.

From this graph it is evident that 8 times in the last 10 years Nifty has gone above a PE of 20 and in all the cases there has been a significant retracement.

The current PE of Nifty (Trailing) is 23.73 from an EPS of 238 and this does smell danger to me. The reasons are many from slow earnings growth to slow earnings growth and other factors that can affect the flow of cheap money in to the country.

But this does not mean that I am bearish on the Indian economy. Just that I am not that comfortable with the high valuation at this point of time.

May be the markets can stretch little bit more but the risk reward ratio does not favor for investment at this time. The consensus earnings growth for Nifty for FY11 is 10% which can take the Nifty EPS to 260 in the most optimistic case but that is again 3 Qtrs away.

The average peak PE for the last 10 years is 23.3 (From the table above) so lets stretch it to 25 (I see this as highly unlikely) which gives a Nifty level of 6000 and a correction to 18PE can take it to 4300 levels.

Below is the snap shot of risk vs. reward based on a PE of 240

The most likely scenario is a peak at 5950 levels (max) and a low to 4770 levels. I would not buy for a pop for the next 300 points from 5650 to 5950 rather I would liquidate my holdings on a regular basis and would rather wait for a correction.