In 2015 Sensex
looks relatively well placed
1 Jan, 2015, 07.20AM IST
By Saurabh Mukherjea, CEO - Institutional equities Ambit Capital
Neither GDP growth nor earnings growth has any
meaningful relationship with the investment returns generated by the Sensex.
Investment returns seem to be dependent on three very different sets of
dynamics: (a) Reversion to the mean; (b) The political-economic cycle in India;
and (c) The US monetary policy cycle. Seen against these three set of
'stories', the Sensex looks relatively well placed as we enter 2015. We
reiterate our end-FY16 target of 36000 for the Sensex.
So, if neither GDP growth nor EPS
growth drives the stock market, what drives it? Secondly, are these drivers
predictable at all? Over the last 30 years, there has been a pronounced
tendency for the Sensex's returns to revert to the mean, with the mean being
around 17%, marginally higher than the cost of equity in India (which is likely
to be around 15%).
MEAN REVERSION
Why does mean reversion work so well as a
predictor of Sensex returns over five-year cycles? The best answer we have
heard is from the promoter of one of the largest road building companies in
south India. The promoter told us last week that "when capital is cheap
and abundantly available, the bidding for NHAI contracts is so intense that the
returns from winning these road projects fallHowever, the more aggressive road
building companies take on these contracts. Then over the next 4-5 years these
aggressive bidders gradually slide into financial difficulties. As the
financial backers of these bidders lose money, they get disenchanted with the
sector and the availability of capital dries up. As capital becomes scarce,
there are fewer and fewer bidders for the NHAI and state highway contracts. Then
over the next 4-5 years these aggressive bidders gradually slide into financial
difficulties. As the financial backers of these bidders lose money, they get
disenchanted with the sector and the availability of capital dries up. As
capital becomes scarce, there are fewer and fewer bidders for the NHAI and
state highway contracts. As a result, the returns from taking these contracts
rise. Gradually, that attracts more capital into the road building sector and
another cycle begins."
THE POLITICAL-ECONOMIC CYCLE
The Sensex seems to move in sync with India's
political cycle. In particular, the Indian economy seems to move in 8-10-year
economic cycles, with the beginning of these cycles coinciding with decisive
general election results (eg 1984, 1991, and 2004). Then in the first three
years of these economic cycles, the Sensex seems to appreciate sharply as
investors discount the decade-long economic cycle. So, while the Sensex's
30-year CAGR is 16%, its CAGR during the first three years of each of the
economic cycles (1984-87, 1991-94 and 2004-07) is about 33%.
In India, the power of the cycle to drive stock
market returns is heightened by the fact that for as long as we can remember,
the Indian middle class has been looking for a 'strong leader' who can
compensate for the consistent weakness of the Indian state and give structure
and shape to the country's aspirations.
THE US INTEREST RATE CYCLE
Sensex returns seem to have a relatively tight
relationship with turning points in the US monetary policy cycle. When US
Government bond yields start rising in the wake of the Federal Reserve
signalling a tightening of the US rate cycle, money flows out of the US bond
market and into global equities. Emerging market equities and the Sensex
benefit from this. Almost every period of rising bond yields in the US has been
accompanied by a rally in the Sensex.
What do these three sets of
'stories' portend for India? These stories seem to have the greatest impact on
the Indian stock market when they interplay with each other fully. For example,
in 2004, India was coming out of an economic slump with almost five consecutive
years of negative returns for the Sensex (FY99: -4%; FY2000: 30%; FY01: -28%;
FY02: -4%; FY03: -12%). As a result, the cost of capital was high and,
hence, the available rates of return were juicy. The Sensex was due a reversion
to the mean. The 2004 general election result, which gave the UPA an unexpected
absolute majority in the Lok Sabha, brought to helm the PM-FM team of Manmohan
Singh-Chidambaram, men who had reformist credentials and who investors were
willing to back after the initial post-election hiccup. The Federal Reserve
announced in 2004 that it was going to begin tightening the monetary policy. As
a result, US bond yields started rising from 2004 onwards.
The three stories then combined to give five
consecutive years of positive returns for the Sensex (FY04: 83%; FY05: 16%;
FY06: 74%; FY07: 16%; FY08: 20%).
In a similar vein, the three
stories seem to be in the right place for India going into 2015. India is
emerging from an economic slump with a spate of sub-par years for the Sensex
(FY11: 11%; FY12: -10%; FY13: 8%; FY14: 19%; FY15 YTD: 22%).
The Federal Reserve has indicated by bringing QE
to an end three months ago that at some stage in CY15, rates will start rising.
Going forward, as the US denominated cost of funding rises and provided the
cost of commodities stays muted, India stands to benefit.
