What should long term equity market returns average?

I was thing on this subject and just thought that I will pen down my thinking on the same.

The returns in the stock markets vary from year to year and time to time. The returns in any given year depend on lot of factors like economic growth, interest rates, market sentiments, global factors, liquidity etc. etc. However over a reasonably long period of time the factors that cause short term market movements or volatility should ideally get evened out and the long term returns should ideally be predictable. The long term would take into account various economic cycles as well as bear and bull markets.

Over the last 20 years the average returns from the Indian markets have averaged around 18%. The figure is different for different markets and a market like Japan (purely going by the index) is actually down 75% from where it was 20 years back. However that was after it gave a return of over 20 times in the preceding 20 years. The Nikkei went up from 2000 in 1970 to 40000 in 1990 and today trades at 9500 levels. Similarly lot of the Western markets have been flat to negative over the last 10 years when emerging markets have given very strong returns.

As such it cannot just be quantitative factors but also qualitative factors that determine the long term returns from markets. The factors that should be important to predict long term return are –

Nominal GDP growth – The nominal GDP growth is one of the most important factors that need to be considered in predicting long term returns. Profits as a percentage of GDP can only rise to a particular level and would typically over cycles vary from one end to the other. As such the long term Nominal GDP growth prediction for a country is very important in predicting the long term returns from that country. For example if India is expected to grow GDP at the rate of 8% over the next 20 years and average inflation will be 6% then the nominal GDP growth will be 14%.

Productivity improvements – Productivity improvements will add to the returns that are generated from the stock markets. As efficiency improves the same assets or capital can be leverage to get better returns. Similarly improving labor productivity or productivity due to technological advances adds to the efficiently of the economy and the returns from the stock markets. In strong innovation cycles the returns of the markets will be much higher than other times. A country like India has huge scope of improving productivity in all aspects of its operations. Agricultural productivity is India ex of some crops like Cotton is much below world averages, Poor infrastructure adds to the cost of operations of companies, Inadequate power availability causes loss of production, a poor tax regime adds to the lack of efficiency in various segments of the operations of the corporate sector etc. In many of these fronts there is likely to be significant improvements in India over the next decade. Thus productivity improvements can add anywhere between 2-5% to stock market returns depending on its impact on profit margins and ROCE.

Rerating or derating of markets – Now this is the biggest qualitative factor that makes or breaks the returns from any market. For example it is not that the profits of Japanese companies are down 75% from the year 1990. It’s just that the Japanese markets due to being extremely fancied at one point of time trades at Price to Earnings ratio of as high as 100 times. Today the median P/E would be in the region of 18-20X. Most of the emerging markets due to their better growth prospects in the future have got rerated over the last decade (barring crashes like 2008) and most developed markets have got derated. This swing in the P/E range in which a market trades can cause a drastic impact on the evaluation of long term market returns. As such at any given point of time it is also important to make an estimate of the rerating phenomenon which although qualitative takes into account the earnings growth potential of the markets. Incase the market believes that long term earning growth prospects have significantly improved or deteriorated it will lead to a rerating or derating.

New growth industries and earnings growth – This is another factor which becomes very important in impacting long term returns in any market. The technology revolution in the West starting from the late 1980s and in India starting from the mid 1990s has had a significant impact in enhancing long term returns. IT companies that had no representation in the broad based indices 15 years back today constitute over 20% of the Index. Given the fact that these are also high ROE and cash generating businesses they have improved the ROE of the entire market.

The strength of the Banking /Financial system – The strength of the financial system is another extremely important factor in determining long term economic growth prospects as well as stock market returns. Indian banks after going through an extremely tough and challenging period in the 1990s till the early part of this decade where they had to go through a cycle of high NPA’s has transformed admirably and today is one of the strongest in the world. Lower NPA‘s and strong balance sheets encourage the Banks to grow and that feeds the economy. The Financial crisis in the West has rendered their banking system so weak that it will take them at least 5 years, if not more to emerge from the crisis. As the Money multiplier will reduce and risk aversion will remain high the longer term growth prospects will further reduce.

Any major cycle that benefits a country – Like India benefited from the technology outsourcing revolution and the telecom revolution the countries in the Middle East benefited from the strong up cycle in the crude oil prices. Western economies benefited out of the low cost manufacturing of China and China got the money it required for its development by building exports Godzilla. Australia benefited from the growth of China and the huge demand of minerals it created and so did countries like Brazil. Some of these long cycle moves can significantly change the long term growth cycle and returns from a country. Russia also benefited from the boom in Crude and Gas prices. The key here is to see how the resources gained out the periods of high returns are used.

Global competitive advantage – A global competitive advantage built around your competencies, like China did with cheap labor for manufacturing initially and then moved up the value chain can add returns beyond those of Nominal GDP plus various productivity improvements. All this can actually flow in my rerating the markets as discussed above.

In conclusion the important factor to analyze is the long term returns from the Indian markets. With a nominal GDP growth of 14%, productivity improvements of 2-3% per annum and assuming no rerating due to higher growth prospects the average returns should be in the region of 20% over the next 10 years. In case the better growth prospects lead to the availability of lower cost capital in the long run it can further add to long term returns. It is also a realistic possibility that the markets over a longer period of time will get rerated upwards to a higher average P/E ratio.

In the same time period, given that the long term growth prospects of countries like the US and Eurozone have come down to around 1.5-2% and the fear is more of deflation than inflation the long term returns should be extremely subdued. Also given that most of the developed economies have squeezed out a huge amount of productivity improvements already that is unlikely to add to returns.

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