# A Brief summary of the Micro/Small/Midcap Carnage

**manivannan.g**(manivannan.g) #259

**hitesh2710**(Hitesh Patel) #260

You need to see that the histogram represents balanced fund inflow. The real picture will be depicted by pure equity funds inflow.

**deevee**(Deepak Venkatesh) #261

Hi

SIP flow data has not been released by AMFI for July. Current chart is as below.

Source: AMFI

But Equity Inflows to MFs is available.

Source: Financial Express

If we take a step back there has been a major shift in preferences to invest in capital markets.

Source: Annual RBI data release.

Rgds

Deepak

**furkanalam**(Furkan Alam) #263

Nifty PE touches 28.2 , which is the highest in last 18 years.

Higher than the PE peaks in 2000 and 2008.

On both previous occasion markets fell approx 50% from the peaks.

Would like to hear from some senior members, how they position themselves at such high market levels. I know investing is more about individual companies and their performance, but we cannot just ignore the unbelievable high PE for index. As if the index crashes all companies will fall irrespective of great, good or bad fundamentals. SO what would be an ideal strategy at these levels.

Please share some insights on how to think about this.

@ayushmit @hitesh2710 @Donald @Yogesh_s ----how to do you guys position yourself at a portfolio level.

Other senior members too please share your thoughts.

**AlokBhola**(Alok Bhola) #264

The P/E peaks of 2000 and 2008 also coincided with business cycle peaks, hence the correction was significant. In a cyclical business (as well as overall market), the combo of a high P/E with earnings cycle peak is always very dangerous.

However, the current earnings appear to be close to cyclical lows, not highs. Owing to cyclically low earnings, the P/Es of most indices are optically appearing high, but that is not necessarily a cause of alarm.

As I do not actively track Nifty, I will illustrate my point with figures from the BSE 200 index (my proxy for large cap universe). The current BSE 200 P/E of 25 might optically appear to be very close to the high P/E of 28 reached in Jan, 2008, but you have to combine this with the fact that the RoE (and hence earnings) of its constituents touched a peak of about 25% during 2008 high. However, the current RoE is at a mere 12% (that is very close to 20-yr lows of 10%).

An even more striking illustration of this is provided by the BSE Small Cap index (my proxy for the small cap universe). Its current P/E of 100 is way higher than the peak P/E of 22 in Jan, 2008. However, this has to be read with the fact that the current RoE of BSE Small Cap constituents is a mere 2%, as opposed to the peak 2008 RoE of about 20%. Hence the extreme cyclically low earnings are resulting in an absurdly high P/E for the index.

The better way to adjust valuations for cyclicality is to look at P/B instead of P/E. The BSE 200 peak 2008 P/B was 6.8 whereas the current P/B is is only 3. Similarly, the BSE Small Cap peak 2008 P/B was 4.3 whereas the current P/B is is only 2.4. Hence, the valuations are nowhere near the 2008 peaks.

**ramanhp**(ramanhp) #265

Good point, Thanks. Pardon my ignorance but could you please explain why P/B should be preferred over P/E as an indicator?

**deevee**(Deepak Venkatesh) #266

Hi

Agree with this. I think in the PE thread I had pointed this out but only when the PE and PB are high do we see true peaks.

In the last 1 year PE has been above 90%ile and PB has been below 60%ile. Overall in an equally weighted scenario of both PE & PB we are below 90%ile (no science behind this equal weightage thingy).

So we should skip this analysis and focus on analyzing the results of our held companies, finding things we are confident in or exiting our overvalued holdings

Rgds

Deepak

**AlokBhola**(Alok Bhola) #267

The denominator in P/E, i.e. Earning (EPS) fluctuates quite a lot for indices and companies in cyclical industries, making P/E as an unreliable indicator for valuation comparisons across different cyclical points for **same / similar companies / indices**. The denominator in P/B, i.e. Book Value, on the other hand, is far more stable. Hence P/B is a much better metric for such comparisons.

However, P/B may not be the best metric for valuation comparisons across companies in **different industries**. There, you may have to use P/B with P/E and several other metrics.

**manivannan.g**(manivannan.g) #269

Not sure how wise to implement such obscure ideas. If SEBI really want to save/prevent investors losing money, they can focus on improving corp governance (ex: vakrangee, PCJ with fake buyback announcement) which saves a lot of retail investors. If implemented, might be a mini black swan event or carnage or meltdown or call it whatever.

**dineshssairam**(Dinesh Sairam) #270

I was alarmed by this at first, but at a second thought, it looks like SEBI is mostly worried about leverage.

If at all this goes through, I think it’d be a sensible move. By good chance or bad, the Indian Equity Investor’s accessibility to F&Os have been drastically increased, whereas the education level required to dabble in those kind of complex instruments is almost non-existent. Except at the top, maybe 25-30 education institutions in the country, the level of exposure to Derivatives-related theory and practice is extremely limited.

From a business perspective, brokers will obviously be the most hit, followed by F&O trading gurus.

Trading limit on Retail Investors

**devaki.tripathy**(Devaki Nandan Tripathy) #271

The problem is not the mindset of the Government, the problem is law of unintended consequences. People who speculate will continue speculating, but now in bucket shops illegally in stead of stock exchanges legally. Government and exchanges will be the major losers here.

Wherever they teach too, its mostly limited to Black Scholes Model of option pricing. Except for speculators, derivatives are also used by institutions for hedging. Any implementation of a half baked idea here will be detrimental to the markets and participants, IMHO.

**pkk123**(pkk123) #272

Black Scholes won the Nobel for option pricing theory and then went bankrupt twice trying to play it

**dineshssairam**(Dinesh Sairam) #273

Black-Scholes is just a guideline. Wall Street went overboard with it, trying to write complex Options using the formula. In the 2008 Berkshire Hathaway Chairman’s Letter, Warren Buffet highlighted the follies of Black-Scholes (Although he admitted that BH itself uses Black-Scholes to price their Options):

"The Black-Scholes formula has approached the status of holy writ in finance, and we use it when valuing our equity put options for financial statement purposes. Key inputs to the calculation include a contract’s maturity and strike price, as well as the analyst’s expectations for volatility, interest rates and dividends.

If the formula is applied to extended time periods, however, it can produce absurd results. In fairness, Black and Scholes almost certainly understood this point well. But their devoted followers may be ignoring whatever caveats the two men attached when they first unveiled the formula.

It’s often useful in testing a theory to push it to extremes. So let’s postulate that we sell a 100- year $1 billion put option on the S&P 500 at a strike price of 903 (the index’s level on 12/31/08). Using the implied volatility assumption for long-dated contracts that we do, and combining that with appropriate interest and dividend assumptions, we would find the “proper” Black-Scholes premium for this contract to be $2.5 million.

To judge the rationality of that premium, we need to assess whether the S&P will be valued a century from now at less than today. Certainly the dollar will then be worth a small fraction of its present value (at only 2% inflation it will be worth roughly 14¢). So that will be a factor pushing the stated value of the index higher. Far more important, however, is that one hundred years of retained earnings will hugely increase the value of most of the companies in the index. In the 20th Century, the Dow-Jones Industrial Average increased by about 175-fold, mainly because of this retained-earnings factor.

Considering everything, I believe the probability of a decline in the index over a one-hundred-year period to be far less than 1%. But let’s use that figure and also assume that the most likely decline – should one occur – is 50%. Under these assumptions, the mathematical expectation of loss on our contract would be $5 million ($1 billion X 1% X 50%).

But if we had received our theoretical premium of $2.5 million up front, we would have only had to invest it at 0.7% compounded annually to cover this loss expectancy. Everything earned above that would have been profit. Would you like to borrow money for 100 years at a 0.7% rate?

Let’s look at my example from a worst-case standpoint. Remember that 99% of the time we would pay nothing if my assumptions are correct. But even in the worst case among the remaining 1% of possibilities – that is, one assuming a total loss of $1 billion – our borrowing cost would come to only 6.2%. Clearly, either my assumptions are crazy or the formula is inappropriate.

The ridiculous premium that Black-Scholes dictates in my extreme example is caused by the inclusion of volatility in the formula and by the fact that volatility is determined by how much stocks have moved around in some past period of days, months or years. This metric is simply irrelevant in estimating the probability weighted range of values of American business 100 years from now. (Imagine, if you will, getting a quote every day on a farm from a manic-depressive neighbor and then using the volatility calculated from these changing quotes as an important ingredient in an equation that predicts a probability-weighted range of values for the farm a century from now.)

Though historical volatility is a useful – but far from foolproof – concept in valuing short-term options, its utility diminishes rapidly as the duration of the option lengthens. In my opinion, the valuations that the BlackScholes formula now place on our long-term put options overstate our liability, though the overstatement will diminish as the contracts approach maturity.

Even so, we will continue to use Black-Scholes when we are estimating our financial-statement liability for long-term equity puts. The formula represents conventional wisdom and any substitute that I might offer would engender extreme skepticism. That would be perfectly understandable: CEOs who have concocted their own valuations for esoteric financial instruments have seldom erred on the side of conservatism. That club of optimists is one that Charlie and I have no desire to join."

**manivannan.g**(manivannan.g) #274

Hi, in this result season I see many companies posting v.good set of numbers, but most of them endup in profit booking, and goes in downward trend. Is this some sort of trend/indicator to be aware of or just because of market mood ?

For me I think, It’s not because of “stock is already priced in”, due to the recent correction, most of those companies are available at decent valuation.

**Gaurav_Agarwal**(Gaurav Agarwal) #276

We can assume that they are thinking about derivatives, but you never know what Indian policy makers will end up doing and what logic/justification they will give for that. I think we should open a news thread for this and try to track when SEBI is putting this policy for public discussion and take active part in that.

**timedimpulse**(timedimpulse) #277

Agreed. Intervention in F&O is their foot in the door of curbing our constitutional right to speculate. It has emboldened them now to try and curb any direct investment in cash.