How Traffic Light Signal can help us understand Equity markets 

I have received a mail from my friend regarding equity market performance. I think it is very useful for all of us. So here I am giving you same mail content as I have received:

I am sure you would agree that the role of Traffic Light Signals in our day to day lives cannot be undermined (It's a different story that we try to jump signals when the traffic constable is not in our radar). The same traffic light approach was introduced around a decade back on the labels of food products (Green Dot means Vegetarian and Red Dot means Non-Vegetarian) and believe it or not, now it has become very easy for us to identify whether the product is suitable for us or not. I still remember how I sometimes ended up buying Chicken Maggi instead of Maggi Masala because of the similar packaging. Now a days even many medicines are mandated to carry out such distinct colour marks. This helps right from a 5-year old kid to 85-year old grandma in understanding the suitability of the product. What a simple yet powerful concept.

Recently, IDFC Mutual Fund has has come out with the usefulness of the same Traffic Light signals in understanding Equity Markets in India. Sounds crazy!!! When I first looked at the study, I was also amazed and realized how things can be made easy and simple enough to educate the retail investors considering that in our country only 10% of the people are financially literate. In this analysis, they have a done a research on the performance of Daily Sensex P/E (basis trailing 12 months earnings) from the period 2nd June 1995 to 30th June 2012 and this is considered as a fairly decent time frame from the point of view of the efficacy of this study. P/E stands for Price i.e a valuation ratio of a company's current share price compared to its per-share earnings. For example, if a company is currently trading at Rs 43 a share and earnings over the last 12 months were Rs 1.95 per share, the P/E ratio for the stock would be 22.05 (Rs 43 / Rs 1.95).




As you can see from the above chart, when the markets are in the Green Zone i.e PE Ratio < 16 (signal for buying), it has received only 8% of the net inflows (Total inflows less Total outflows). On the other hand when the market is in Red Zone i.e PE Ratio > 19 (signal for not buying) it received 65% of the Net inflows. Even a Class IV student knows that the right time to buy is when the markets are low and vice-versa. What an irony, but this is how world over investor behaves.

In this chart, it shows us when to invest and when not to invest based on the last 17 years of the SENSEX. If you would have invested when the signal was green, you would have made handsome money both in the short term (3 years or so) and in the long term (5 years+). Doesn't this look so easy and no brainer. Yet 90% of the people chose to do the opposite and then blame their stars.

Finally, this chart tells you that when you follow the discipline of investing using the Traffc Signal approach, chances are that you will make smart gains. When the markets have been below <16 PE ratio, the next 3-year average annualized returns have been 21%.

The whole idea of sharing these insights with you is to advise you that investing in Equity markets is all about common sense investing. Many a times we pay attention to so much of micro details and  the noise emanating from various media channels and in the process forget the basics of investing.

Pls note this is just a study based on the past data and as you would know past performance may or may not be sustained in future.

Kindly share this wonderful analysis with your friends / colleagues so that next time when we see the Equity market signal, we know what to do. Isn't this a great idea, Sir ji.........

Regards,

Arvind Trivedi

Certified Financial Planner
arvind.trivedi79@gmail.com