SENSEX PRICED TO DELIVER ATTRACTIVE MEDIUM-TERM RETURNS

THE LARGEST CORRECTION SINCE 1980

The Sensex declined 59.3% in real terms in the year to December 6, 2008. If the current levels sustain until year-end, this will go down as by far the steepest descent since 1980. The worst performance for the index pre-2008 was a 27.6% real decline in 1995. The index’s yearly inflation adjusted appreciation averaged 12.9% since 1980 (with a volatility of 32.7%). In 2008 so far, the market undershot the yearly average by more than 2-sigma. The key question is whether valuations already reflect the significant economic slowdown that lies ahead. The answer is important to gauge the prospects for aggregate market returns over the next few years.

VALUING THE MARKET BASED ON PRICE TO TRAILING NOMINAL GDP

A reasonable estimate of equity returns over longer periods depends on sustainable earnings and risk appetite as reflected in the multiple the market attaches to those aggregate net profits.

At cyclical turnings points, using current earnings (or even bottoms up aggregated forward earnings) for valuation remains fraught with problems. Studies document that analysts recognize the cyclical reality too late. Thus, based on yearly trailing or forward P/E ratios, the market may continue to look overvalued in the face of an upturn or undervalued even when a macro-downturn seems imminent.

A better valuation method would be to use some form of normalized earnings. Alternatively, price to trailing one-year nominal GDP could also serve the purpose. Sales tend to be less variable compared to profits. Thus, nominal GDP – economy wide sales - can be an important benchmark when judging sustainable earnings potential.

THE MARKET SEEMS UNDERVALUED

Based on the data since 1980, the average for this multiple measured 0.22 versus 0.17 as of close on December 6 (based on IMF’s estimate of GDP for 2008). The mean since 1991 figured 0.27 versus just 0.15 for the 10-years ending in 1990. The lowest value for the parameter – 0.11 – was registered at the end of 1980 and 1984.

There can be several good arguments as to why the decade of 1980s was not representative of the current reality. If we simplistically assume that investors assess future growth prospects based on a reasonable moving average of the variable in question, then expansion expectations would have been markedly lower in early 1980s. Real GDP growth in 1970s averaged just 3.0%. And not that 1970s had been a decade of abnormally depressed activity. The Indian economy took-off in the second half of the 1980s. There was no precedent of sustained 6.0% plus growth till then. Additionally, the volatility of real GDP growth declined steadily over the last three decades as the contribution of largely rain-fed agricultural sector fell.

It is tempting to argue that the current reality suggests an entirely different set of possibilities. A caveat though – 28-years of data is just not enough. Almost 200-years of data for the U.S. economy present a picture of remarkable stability of real returns of about 7% per annum. The United States went through numerous structural changes during the last 2-centuries, but 7% proved to be iron clad over long periods. That is not to say that returns did not diverge from this number. However,movements away from equilibrium were corrected by subsequent performance dynamic.

VALUATION AT INCEPTION MATTERS FOR RETURNS

Initial inspection suggests a negative correspondence between starting valuation and subsequent 5-year average returns. The sub-par returns in the second half of the 1990s seem to be a function of the stratospheric price to nominal GDP ratios in 1993 and 1994.

A graph with a few turning points does not lend statistical validity. A simple regression of Sensex’s yearly real returns with 1-year lagged price to nominal GDP as the dependent variable presents a robust relationship.

Real Returns = 53% - 145% * Price to Nominal GDP (-1)

Valuation explains 15% of 1-year forward returns. The coefficient for the price to nominal GDP ratio is negative and statistically significant at the 5% level.

THE GOOD THING ABOUT THE CARNAGE OF 2008: ENTRY POINT FOR MEDIUM-TERM INVESTORS

Often markets cheapen over extended periods by continued earnings growth and range-bound price action. Sub-par price appreciation even in the face of improved economic prospects during 1994-1997 reflects this phenomenon. Real GDP growth averaged 7.0% over 3-years, but stocks failed to deliver.

The sharp decrement in the current year worked to correct the extreme overvaluation (0.45 as of 2007-end) in one shot. The market now looks attractively priced for investors with a medium-term horizon.

The above analysis does not imply that a bottom has been made. The great depression tail-event does not seem to be priced in yet. Additionally, the lowest valuation seen over the last 18-years (2002-end) would imply a Sensex level of about 7500. Going back to the 1980s would suggest still more downside.

Yet, a global recession is now a reality and the already significant equity downdraft globally most likely accounts for it. Cash credit markets in the U.S. continue to price in economic cataclysm. Given the substantial and most importantly, timely policy stimulus in the U.S. and elsewhere, credit pricing will likely converge to equities in the times ahead. Looking back from 2013 investors will probably recount equity returns that will beat fixed income by a decent margin.