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What Returns Will the Stock Market Give from Here?

Aug 18, 2016

In this issue:
» Coming up: A US$100 billion IPO
» A crisis bigger than 2007-08 in the offing?
» ...and more!
00:00
Rahul Shah, Co-Head of Research

That is, at once, the most commonly asked question as well as the trickiest to answer.

The markets can be quite random. Often, you expect one thing to happen, and what you get is something else altogether. But since it's such a hot question, I decided to (bravely) venture into giving you a reasonable, non-speculative answer to it.

First off...and this is where most investors get it wrong...is valuations. Market returns from any given point are inextricably linked to the valuations you buy at. Now, financial jargon is enough to scare off even the bravest of souls, but please bear with me. It's actually pretty simple...

All 'valuations' refers to is the price of a stock relative to the underlying business's profits or assets. So if a stock is trading at Rs 200 and the business's net worth represented by that stock is Rs 100, that's a valuation of two times (2x) net worth. We can do a similar calculation for the stock price relative to the profits of the business.

What are the market's valuations right now? Well, relative to net worth, the average large company's stock (represented by the BSE Sensex) is trading at about three times (3x) the underlying business's net worth.

So the question, more wisely framed, would be 'What Returns Will the Stock Market Give if One Buys at Current Valuations?'

Now, as they say, history doesn't repeat itself, but it certainly rhymes. So I did some serious number crunching. I went all the way back to 1990 to look at the entire twenty-six years of stock market history since then. After all, the bigger the sample size, the stronger the conclusions from the data.

What I was looking for, of course, were past valuations similar to those prevailing now. That is, I wanted to see at what different points the BSE Sensex was trading at about three times net worth. Then, more importantly, I wanted to see the kind of returns the market gave over the next five years.

And here's the answer:

Date Next 5 Year's Returns (point-to-point)
25-Mar-91 180%
14-Nov-95 26%
12-Jun-97 -16%
09-Jun-99 22%
20-Dec-00 130%
28-Nov-03 79%
10-Jun-04 206%
13-Oct-08 82%
11-May-09 97%
Average 90%

Data Source: Equitymaster, Ace Equity

Now, is an average return of 90% over a five-year period good? Let's see what these returns look like on an annual compounded basis to get a better idea:


So there it is.

Over the last twenty-six years, each time the markets have traded at valuations of around 3x (as they are today) they have gone on to give annual returns ranging from -3% to 25% over the next five years. On average, they've given returns of 12.3%. Add in dividends of 1% to 2%, and you end up with an average of 13% to 14%.

But this doesn't solve one important problem. That is what you can expect...on average. But with this kind of volatility in returns even over a five-year period, what if you end up with a sour patch? What if you get an episode of -3% returns, rather than one of the better ones?

Well, one of the reasons for these volatile results is the current market level. Though not exorbitant, valuations of three times net worth can't really be called cheap either. When market valuations are lower, the probability of a bad five-year patch goes down significantly.

Nonetheless, that's where we are today.

But despair not. There is still a trick investors can use to get more consistent returns, even if you buy at these levels. A trick that I will reveal to you only next week. Stay tuned...

Do you know what trick you can use to get more consistent returns from the stock market? Let us know your comments or share your views in the Equitymaster Club.

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------------------------------

02:50 Chart of the day

That the world's largest company is a tech giant is no longer a secret. However, come 2017 and the equation could well shift. Sitting atop the list of the world's most valuable company could be Saudi Arabia's state owned oil company Aramco. Initial estimates suggests that the company, which is coming out with an IPO the size of a mammoth US$100 billion and by far the world's largest ever, could be valued at a whopping US$2 trillion. To put the numbers in perspective, this is roughly equal the size of India's GDP.

For a company that controls nearly one fifth of the globe's petroleum reserves and pumps more oil than the four publicly traded oil companies combined, the IPO size and the company's subsequent market cap doesn't really come as a surprise. What does come as a surprise is its public listing as the company's financials have always remained a mystery. With the IPO though, this veil of secrecy would certainly be lifted. Either ways, if the IPO does go through, it is likely to remain the largest ever for quite some time to come. It will be a record difficult to match let alone beat in our view.

Aramco's IPO the World's Biggest by a Distance


03:45

Now, here's an interesting analogy. With the Olympics in full swing, noted Economist Dr Edward Yardeni has connected it with the current bull market and argued that if this bull market was competing in the Olympics, it could well and truly have been disqualified. The reason? Well, as per him, the bull market has been injected so many times with steroids that the bears are all saying that this is not a fair game.

Steroids in this case being the interest rate cuts and the relentless money printing effected by some of the biggest central banks of the world. Interestingly, central bank officials are the ones who usually end the race for stock market bulls. This time however, they are doing everything they can to keep the rushing bull charged up and charging.

Well, we couldn't agree more with Yardeni on this. None of the issues that caused the 2008 financial crisis have been addressed. On the contrary, the global economy has been supplied with still more money and debt when it was these very instruments that caused the crisis in the first place. Consequently, the problem has snowballed many times over and when it all unravels, there could be a much bigger crisis than the one we witnessed back in 2007-08.

04:40

Meanwhile, Indian markets are trading strong today with the BSE Sensex higher by around 150 points at the time of writing. Mid and small cap indices are also showing buoyancy with the Small Cap index up by around 1%. Amongst sectors, telecom and banking stocks were found to be the most in favour.

04:56Investment mantra of the day

"Unless you can watch your stock holding decline by 50% without becoming panic-stricken, you should not be in the stock market." - Warren Buffett

This edition of The 5 Minute WrapUp is authored by Rahul Shah (Research Analyst).

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1 Responses to "What Returns Will the Stock Market Give from Here?"

Rajanikanta Verma

Aug 19, 2016

Good stock-picking is the answer. Even when the SENSEX is trading at 3 times its value there would be stocks which are under-valued and the trick would be to spot them for investment.

Like (1)
  
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