How’s the view from atop Mount 50k?

Cynics may say it’s just a number, but market participants were jubilant last week when the Bombay Stock Exchange Sensitive Index, also called the Sensex, crossed the 50,000 level briefly on January 21. Scaling the 50,000 mark, even if only briefly, perhaps symbolised the victory of the stock market over the pandemic and promised continued riches to them.

The recent feat aside, it has been quite a remarkable journey for the Sensex since its launch in January 1986. From ring-trading in fragmented regional stock exchanges across the country, controlled by few heavy-weight stock brokers, India’s stock market has evolved into an institution that matches its global counterparts in almost every respect.

The journey has also been mostly happy for investors who decided to hop on to the stock market bandwagon, despite the social stigma attached with playing in the satta bazaar prior to the 1990s. If we consider plain vanilla annual returns since 1981, the index closed with gains in seven out of every 10 years. The Indian benchmark has also performed much better than other global indices since 1980, giving annual returns of 15 per cent. But as the disclaimer goes, past performance is not a guarantee of future returns.

Can the index keep up this scorching growth? Now that mount 50k has been scaled, will it be a downhill ride from here? Well, it is really difficult to predict stock price moves that are influenced by both hard numbers as well as wild expectations of investors. While growth in Indian stock prices will continue due to the relative advantage of Indian equities, long-term returns will be far more moderate compared to the past.

Slowing returns

There are many who believe that stock price moves are random walks and have no relation to fundamentals. While phases of market exuberance, such as the current one, makes one think that this may be true, it is not so. Stock price movement is tied to underlying economic growth and corporate earnings. The disconnect tends to appear because stock prices move ahead of the actual change in fundamentals, based on projections and assumptions of market participants.

The fallout of this line of thought is that the Sensex cannot continue to grow at the searing pace that it has recorded in the past. The compounded annual average growth rate of the Sensex from 1980 at 15.5 per cent is largely because the economy moved from a ‘Hindu’ rate of growth, prior to the 1990s, to double-digit growth in early 2000, thanks to economic liberalisation that resulted in expanding corporate earnings.

Foreign portfolio investors, too, became more dominant in the early 2000s and the Sensex mirrored this high-growth phase with compounded annual returns of 43 per cent between 2002 and 2007.

With economic growth tapering from 2010 in line with global slowdown, excessive leverage affected the banking system and larger companies, impacting Sensex returns as well. The CAGR of the Sensex between 2010 and 2020 was 9.5 per cent, compared with 15 per cent between 2000 and 2010. The average annual returns between 1980-1990 and 1990-2000 were over 20 per cent.

With the economic picture not too rosy, growth in Sensex returns will move lower over the next decade. Besides the general economic slowdown witnessed since 2019, we now have to contend with the impact of the pandemic that is going to shrink the economy by 7-9 per cent in FY21, going by estimates of various research houses.

What’s the growth likely to be?

Also, as the Indian economy matures, the GDP growth, interest rates as well as inflation will taper down over the next few decades. Since stock price returns are linked to economic growth, long-term returns of the Sensex will probably halve from the current 15 per cent.

A BusinessLine analysis done to arrive at the expected returns from equities up to 2050, which was published in January 2018 ( https://www.thehindubusinessline.com/portfolio/equities-the-road-to-2050/article8721170.ece ), had pegged equity returns over the next three decades between 8 and 11 per cent. But the global slowdown since then, coupled with the pandemic, is likely to impact this projection.

An analysis of the rolling returns of CAGR of the Sensex since 1980 also shows that an investor who held Sensex stocks for any 10-year period, could make only 7.6 per cent return in 2020. Excluding 2019, such investors have not made double-digit returns since 2016.

It needs to be noted that India’s nominal GDP growth had reduced to 7.5 per cent in FY20. With growth in company EPS closely linked to this growth, returns in this range appear more rational.

Another way to arrive at equity returns is by adding the equity risk premium to the risk-free rate of return (G-Sec yield). With interest rates in the economy on a downward trajectory, the return calculated through this method would also move lower.

What’s the USP?

While the returns that investors make may be less, Indian equity will remain the most sought after, given the country’s demographic profile, with greater proportion of working-age and relatively younger population that will continue to drive domestic consumption, fuelling demand for companies catering to the local market.

This will be in contrast to other countries that face an increasing proportion of ageing population and declining number of people, curtailing demand.

The lower penetration of equity in India is another factor that will aid demand in the future. As falling interest rates make more savers move some money into stocks, demand will ensure that stock prices continue to grow, albeit at a reduced pace.

Investors will be hoping that the Budget sets the right tone in instilling confidence about future prospects of the economy and does nothing untoward by way of sudden increase in taxes on equity or equity-related instruments.

Equity market is the lone bright spot in FY21 and it’s hoped that the Finance Minister does nothing to spoil that.

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