In my decade-long career of covering stocks in two different markets - UK and India - I have not been able to find any link between the stock market and economic growth or between the stock market and EPS growth. So, if neither GDP growth nor EPS growth drives the stock market, what drives the stock market? This column focuses on the three sets of stories which drive the Indian market.
Story 1: Mean reversion
Over the last 30 years, there has been a pronounced tendency for the Sensex's returns to revert to the mean, with the mean being around 17 per cent, marginally higher than the cost of equity in India (which is likely to be around 15 per cent).
Why does mean reversion work so well as a predictor of Sensex returns over five-year cycles? The best answer that we have heard is from the promoter of one of the largest road building companies in south India (the company in question is unlisted). The promoter told us last week that when capital is cheap and abundantly available, the bidding for NHAI contracts is so intense that the returns from winning these road projects fall. However, the more aggressive road-building companies take on these contracts. Then over the next four-five years these aggressive bidders gradually slide into financial difficulties. As the financial backers of these bidders lose money, they get disenchanted with the sector and availability of capital dries up. As capital becomes scarce, there are fewer and fewer bidders for the NHAI and state highway contracts. As a result, the returns from taking these contracts rise. Gradually, that attracts more capital into the road building sector and another cycle begins.
Story 2: The political-economic cycle
The Sensex seems to move in sync with India's political cycle (which in turn seems to have a profound influence on India's economic cycle). In particular, the Indian economy seems to move in eight-ten-year economic cycles, with the beginning of these cycles coinciding with decisive general election results (for example, elections in 1984, 1991 and 2004). Then in the first three years of these economic cycles, the Sensex seems to appreciate sharply as investors discount the decade-long economic cycle. So, whilst the Sensex's thirty-year CAGR is 16 per cent, its CAGR during the first three years of each of the economic cycles (1984-87, 1991-94 and 2004-07) is about 33 per cent.
This sort of political-economic cycle has been observed in numerous countries and is a well-documented phenomenon in economic literature. In India, the power of the cycle to drive stock market returns is heightened by the fact that for as long as we can remember, the Indian middle class has been looking for a 'strong leader' who can compensate for the consistent weakness of the Indian state and give structure and shape to the country's aspirations.
In fact, if one studies Indian history over the last 3,000 years, what is remarkable is that with the exception of the Mauryas in the third and fourth century BC and the Guptas in third and fourth century AD, no other Indian ruler has been able to build anything which looks remotely like a strong 'state'. Even in the case of the Mauryas and the Guptas, the empires that they built lasted less than two generations and did not have the power to tax economic activity in anything like the way that Chinese rulers have had since 500 BC. Nor were India's greatest rulers able to impose a common set of laws or common set of weights and measures on this disparate land. (China and Europe's deviation from India in this regard could not be sharper.) However, successive millennia of failure to build a strong state have not dented the Indian middle classes' hope of a strong leader who will impose order on this unruly land. As a result, almost every decisive general election result fuels the hope that 'this time we have found our messiah'. That hope in turn fuels the Sensex for three-four years.
Story 3: The US interest rate cycle
Sensex returns seem to have a relatively tight relationship with turning points in the US monetary policy cycle. In particular, when US government bond yields start rising in the wake of the Federal Reserve signaling a tightening of the US rate cycle, money flows out of the US bond market and into global equities. Emerging market equities and the Sensex benefit from this. Almost every period of rising bond yields in the US has been accompanied by a rally in the Sensex.
What do these three sets of 'stories' portend for India?
These stories seem to have the greatest impact on the Indian stock market when they interplay with each other fully. For example, in 2004:
- India was coming out of an economic slump with almost five consecutive years of negative returns for the Sensex (FY99: -4 per cent; FY2000: 30 per cent; FY01: -28 per cent; FY02: -4 per cent; FY03: -12 per cent). As a result, the cost of capital was high and hence the available rates of return were juicy. The Sensex was due a reversion to the mean.
- The 2004 general election result, which gave the UPA an unexpected absolute majority in the Lok Sabha, brought to the helm the PM-FM team of Manmohan Singh-Chidambaram, the men who had reformist credentials and the men whom investors were willing to back after the initial post-election hiccup.
- The Federal Reserve announced in 2004 that it was going to begin tightening the monetary policy. As a result, US bond yields started rising from 2004 onwards. The three stories mentioned in this note then combined to give five consecutive years of positive returns for the Sensex (FY04: 83 per cent; FY05: 16 per cent; FY06: 74 per cent; FY07: 16 per cent; FY08: 20 per cent).
- India is emerging from an economic slump with a spate of sub-par years for the Sensex (FY11: 11 per cent; FY12: -10 per cent; FY13: 8 per cent; FY14: 19 per cent; FY15 YTD: 22 per cent).
- Enough has been written about the decisive nature of the 2014 general election result for me not to belabour the point further here.
- The Federal Reserve has indicated by bringing QE to an end three months ago that at some stage in CY15 rates will start rising. The ten-year US government bond yield has risen from 155 bps 29 months ago to 225 bps now. Going forward, as the USD-denominated cost of funding rises and provided the cost of commodities stays muted, India stands to benefit.
Hence, in spite of my misgivings regarding the strength of the incipient economic recovery and the damaged state of the banking system, we remain positive on the Sensex and enter the New Year with an end-FY15 Sensex target of 30K (first highlighted in our 19 May note) and an end-FY16 Sensex target of 36K.
The main risk to my Sensex targets arise from the fragile state of the global economy. In particular, with a large part of the globe still fighting deflationary forces, a major currency devaluation war is becoming increasing likely over the subsequent 12 months, with China likely joining Japan and the EU in attempts to devalue their respective local currencies. A currency shock driven by a Chinese devaluation is a risk which, whilst hard to quantify, could lead to FII outflows from India (given the pressure that a Chinese devaluation will place on the RBI to devalue). Since FII inflows have a great impact on Indian markets, FII outflows might see Indian markets tumble.
Saurabh Mukherjea is CEO of institutional equities at Ambit Capital. The views expressed here are personal.
This column appeared in the February 2015 Issue of Wealth Insight.
This article was originally published on February 13, 2015.
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