The Hindu Business Line : Long-term market behaviour easier to predict

THE speed and the extent of the movement of the equity market from 6000 levels to 8000 levels in nearly three months has surprised many an investor and observer of the market and also proved many market-timers wrong (recollect the expectation of many about the index going to 5800 levels when it was nearly 6200).

This highlights and proves once again the futility of trying to time the market and to predict their short-term movements.

Surprising though it may seem, it is less hazardous to predict the longer-term movements of the market.

This makes equities a unique asset class in which the uncertainty of returns reduces with time unlike many other asset classes where uncertainty tends to grow. Consider this.

Given the secular growth phase that the economy is passing through, it is easier to estimate that after five years, assuming a normal profit growth rate of 15 per cent per year and reasonable PEs, the Sensex should be between 12000 (at 11 PE) and 16000 (at 15 PE), than it is to guess the timing and manner of market movements en route.

The point is that despite reasonable clarity on the destination, the route that the market will select to reach that destination is not known in advance.

Investing in equities is thus like embarking on a long journey where the destination is known with a degree of certainty but the route is very uncertain.

The destination is known with greater clarity because the equity market over long periods of time is a slave of earnings and of growth in earnings. In fact, over long periods, returns from equities must track corporate profit growth rates for very simple reasons:

If markets continue to lag profit growth rates, the P/Es will keep on falling and ultimately start approaching zero, which is not reasonable.

On the other hand, if equity returns continue to outpace profit growth rates, P/Es will keep on rising and move towards very high levels and ultimately start approaching infinity which is again not reasonable. But equities over short periods are simply volatile!

Therefore, one can say with a higher degree of confidence what is likely to happen to equities over the next five years than one can say what is likely to happen over the short periods.

Over short- to medium- time-frames, even high or low PE multiples are not a guide to the short-term prospects of the market. If the market is undervalued (are trading at low PE multiples) they can become even more undervalued as happened in FY 02-03; on the other hand, if they are overvalued it does not mean the market will fall in the short run and can actually become more overvalued in the short run as was the case in 1991-92 and again in 1999-2000.

The message is simple: No matter what we do, it is quite hard to predict the short-term movements of the market (for those who are still not convinced of this, just go back to April 2005 and look at the expectations then and the market movements since then).

(Edited extracts from a note by Mr Prasanth Jain, Chief Investment Officer of HDFC Mutual Fund sourced from the latest monthly performance report.)

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