Nov 18, 2008|
Sensex: 17,000 in three years?
We made an interesting observation the other day. Thanks to the pounding that it has received since the onset of the year 2008, the earnings yield of Sensex is now a shade below 8%. This is comparable to the yield on the 10 year G-secs (government securities), also a shade under 8%. What does this mean? This means that Mr. Stock Market feels that over the next 10 years, returns from the Sensex and the G-sec yields are going to be identical. Is that possible? We don't think so. The coupon payment on the G-secs remains constant throughout the tenure of the bond. However, the coupon for the Sensex is nothing but the aggregate earnings of the companies that constitute the Sensex. Are these earnings going to remain constant in the backdrop of the economy going at a nominal rate of 12%-13% (real GDP growth rate of 6%-7% plus inflation of 6%)? Quite unlikely.
Thus, Mr. Market seems to be out of his mind. What else would explain the similar yields between two different asset classes when one is likely to yield a much higher coupon rate 10 years from now than the other? To put things in perspective, 10 years from now, coupon from the Sensex at a 12% growth rate, would be more than three times the coupon from the current G-sec.
Is this insanity of Mr. Market a new phenomenon or has it happened in the past. Data from 2000 that is available with us shows that there have been four such occasions since June 2000 when the yields on both the Sensex as well as the G-sec yield have crossed each other's paths.
As can be seen from the above chart and as mentioned before, the yield on G-sec was equal to Sensex on four previous occasions.
In September-October 2002, the yield on both the Sensex and G-sec was equal. From that period onwards, if we track the performance of the Sensex for the next three years i.e. till September- October 2005, it grew at around 70% CAGR.
Similarly, during the period April 2004, August 2004 and May 2005 when G-sec yield was again equal to the Sensex yield, the markets gave a fabulous return of 57%, 66% and 60% CAGR respectively over the next three years.
Thus, after analyzing the relationship between the G-sec yield and Sensex yield and market performance, we can conclude that whenever the G-sec yield and the Sensex yield have converged, the markets have provided outsized returns over a three year horizon.
The Sensex yield and the G-sec yield have once again converged. Hence, the most obvious question follows. What would be the Sensex levels three years from now? Since coupon payments from Sensex grow with time, it should command a lower yield than the 10 year G-secs. A 6% yield seems a reasonable enough assumption. Thus, assuming a 6% yield and a 12% growth in earnings of Sensex companies, a Sensex level in the region of 17,000 three years from now does not seem farfetched. This translates into a very attractive 23% CAGR from the current levels, higher than most asset classes on offer. It should be however borne in mind that the assumption of a reduction in the Sensex yield and a 12% growth in earnings of Sensex companies is central to our attainment of the target.
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