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
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
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
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.
Any major cycle that benefits a country – Like
Global competitive advantage – A global competitive advantage built around your competencies, like
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