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The Secret to More Consistent Returns from the Stock Market

Aug 27, 2016

In this issue:
» US Fed to raise interest rates soon?
» A round up of the markets
» ...and more!

00:00 Chart of the day

Rahul Shah, Co-Head of Research

Last week, I wrote to you about an important question most investors look for an answer to: 'What Returns Will the Stock Market Give from Here?' In finding the answer, we saw that market returns from any given point are inextricably linked to the valuations you buy at. So considering current valuations was the first and most vital step.

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.

Like I told you, I did some serious number crunching and went all the way back to 1990 to look at twenty-six years of stock market history since then. What I was looking for, of course, were past valuations similar to those prevailing now. That is, at what different points the BSE Sensex was trading at about three times net worth. And, more importantly, what kind of returns did market gave over the next five years? And the answer was:

Whenever the BSE Sensex has traded at three times net worth...

So each time the market traded at valuations of around 3x over the last twenty-six years, it went on to give annual returns ranging from -3% to 25% over the next five years. On average, it gave returns of 12.3%.

But that didn't solve one important problem. That's was the range of returns you could expect - on average. But with this kind of volatility in returns even over a five-year period, what if you ended up with a sour patch? What if you got an episode of -3% returns, rather than one of the better ones?

And that takes me to the promise I made to you: that I'd reveal a trick you could use to get more consistent returns, even if you bought at current market levels.

In other words, I promised to take the chart above, and turn it into something less volatile, and less scary!

And here it is:

Whenever the BSE Sensex has traded at three times net worth...


Yes, in sifting through all the data, what I began to realize is that even over a span as long as five years, the valuations of the market at the end of the five years as well as the phase of economic cycle during the period covered became all important to returns.

For example, if you look at the first chart, the worst returns came in when investors bought in June 1997 and June 1999. That's because those five year periods ended in June 2002 and June 2004. The former was a time when market valuations were down in the dumps. The latter on the other hand - the 1999 to 2004 period - covered five years of the Indian economy going practically nowhere.

But as an investor increases his holding period to ten years, the harmful effects of the economic cycle as well as market valuations get taken care of automatically. And therefore, the variability of the returns one earns goes down very significantly!

And that, dear reader, is the secret to getting more consistent returns from the stock market; even when you buy at levels such as those prevailing these days.

Have you had any personal experiences in boosting the quality of your returns from stocks by holding on to them longer? Let us know your comments or share your views in the Equitymaster Club.

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02:55

US Fed Chairperson Janet Yellen made an important speech yesterday. At the annual gathering of central bankers at Jackson Hole, Wyoming, she hinted that the Fed could raise interest rates soon.

Specifically, she said the case for raising interest rates had 'strengthened' in recent months. Why? She citied improvements in the US labour market (i.e. more people finding jobs than a year ago), an expectation of moderate economic growth and that the US economy was nearing the Fed's targets.

Of course, she did not say when the Fed might hike rates, only that rate hikes would be gradual. But these comments have only reinforced the prevailing notion that a rate hike is coming soon, perhaps as early as next month.

We have heard all this before. As always, we take such statement with a pinch of salt. In yesterday's premium edition of The 5 Minute WrapUp, my colleague Ankit Shah, had this to say on the possibility of a Fed hike.

  • "For more than a year and a half, the Fed has been adamant on raising the Fed funds rate. This is the same as the Repo rate that the RBI sets in India. Ever since the Fed ended its QE policy, talk of a rate hike was ever present.

    Yet the Fed took a long time to increase the Fed funds rate. They did so only in December 2015 and that too by just 0.25%. Markets crashed the next month and the Fed backed off. Even though markets have recovered and the US economy seems to be showing signs of strength, the Fed seems either unwilling or unable to hike interest rates."

I agree. The Fed fears the consequences of a rate hike. It does not want to upset the apple cart. At the same time, it knows that it must talk of raising rates. If it doesn't talk about it, the Fed risks losing its credibility.

As Bill Bonner has said repeatedly, the Fed won't hike rates, no matter what they say publicly. You can read about it here, here, and here.

04:05

Global markets continued to trade on a weak note in the week gone by. Barring a few, most of the sectoral indices remained in the negative territory. Markets remained under pressure for the entire week on hawkish comments made by the Fed policymakers giving rise to speculations for a rate hike.

However, there was some recovery after the Federal Reserve Chair Janet Yellen did not give any firm indications of raising interest rates in the immediate future. However, as mentioned earlier, she did say that improvements in the labor market and expectations for solid economic growth had strengthened the case for a rate hike that would be undertaken gradually. But volatility persisted after the Fed Vice Chairman Stanley Fisher asserted that Yellen's remarks were consistent with the possibility of two rate increases in 2016, suggesting the likelihood of a September rate hike.

Brazil was the biggest loser (down 2.3%). Among the Asian markets, each of China, India and Japan's indices were down by up to 1.2% each during the week. The US and UK markets were down by 0.8% and 0.3%, respectively. However, markets in France and Germany have managed to stay afloat and posted gains of 0.9% and 0.4%, respectively.

Back home, the Indian indices ended in the red bogged down by weak global cues on the rate-hike uncertainty and profit booking by institutional investors. The BSE Sensex was down by 1.1% for the week.

On the sectoral indices front, consumer durable and oil & gas stocks led the gainers this week. On the other hand, stocks from metal and capital goods witnessed selling pressures.

Performance During the Week Ended 27th August, 2016

04:56Investment mantra of the day

"In the long run, it's not just how much money you make that will determine your future prosperity. It's how much of that money you put to work by saving it and investing it." - Warren Buffett

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

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2 Responses to "The Secret to More Consistent Returns from the Stock Market"

Aditya Mukherjee

Aug 27, 2016

It is true that you get hand full returns on long term investment (12.5%). But you can eat the cake and have it too! -- if you can calculate (by statistic & probability )the near time of market crash and sell before it.You can always buy then to maintain so called longterm prespective/ divident/preferancial share .

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Ranganathan

Aug 27, 2016

Excellent article. The difference in results when period of reckoning increases to 10 years is amazing.
It clearly establishes the definition of long term. Thanks for the well researched gyan.

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