Deepak Shenoy has a great chart which he uses to conclude that all of Indian Stock Market returns can be explained by 4 years 2003-2007. Here is the chart.
However, the chart only tells a part of the story. Here is the same chart along with earnings growth. I have normalized both earnings and price to 100 in the beginning so that you can clearly see the relationship.
As you can see that prices have tracked earnings over the last 20 years (1991 to 2012). So over the long term your returns in the stock market will depend on earnings growth, which in turn will depend on how the economy is doing. India’s GDP averaged over 9% from 2003 to 2007 and around 5.3% from 1991 to 2002. Attached is a chart of India’s GDP growth during this period.
Earnings Growth (left axis) and GDP Growth (right axis) is attached here.
Let me recap, over long terms prices track earnings which tracks GDP growth. Thus, expected returns will more or less depend on GDP growth.
However it is important to note this is expected long term returns and should not be confused with you actual point to point return. In addition to earnings growth point to point return will also depend on PE multiple expansion (or compression). I had done a detailed post on this earlier.
This brings me back to Deepak’s chart. From May 2003 to Dec 2007 the market went from 3,180.25 to 20,286.99 (up 7 times) and PE went from 13.21 to 26.94. If the PE multiple remained the same (i.e. had markets tracked earnings) then the market should be at 9,947.70 (up 3 times). Thus, PE expansion was responsible for most of the returns we saw.
Similarly, from Dec 2007 to Apr 2012 the market went from 20,286.99 to 17,597.42 and PE multiple went from 26.94 to 17.92. If the PE multiple had remained the same the market would have been at 26,455.05. Here is a chart of Price, Earnings and PE. Again Price and Earnings have been normalized at 100 in 1991.
Thus, point to point returns will depend on valuations in addition to expected returns. If the stock market goes from undervalued to overvalued (as it happened from 2003 to 2007) your returns will be higher than expected returns and vice versa.
Currently market PE is around 17 whereas historically it has been around 21 and median is around 19 (averages are impacted by high PE multiples resulting from early 90s scams and 2000s bubble so median may be a better approximation). This indicates that markets are slightly undervalued. So (and I mean over 5 to 10 years) when PE expands to its historical value (around 19) then returns will be higher than what you expect.
This post can be reduced to following mathematical equations:
Point to Point Return = Expected Future Returns + Returns due to Multiple Expansion
Expected Future Return = Earnings Growth ~ ~ GDP Growth
Finally, though I haven’t discussed it in this post but it can be shown that
GDP Growth = Population Growth + Productivity Increases
Valuations will tell you what will happen to PE multiple (e.g. I would expect it to go up from here).
Population Growth is really predictable and is around 1.3% for India.
So, to predict returns all you really need is Productivity Increase .
Let me know if you can predict it .