What Returns Will the Stock Market Give from Here?

What Returns Will the Stock Market Give from Here?

That is, at once, the most commonly asked question as well as the trickiest to answer. 

The markets can be quite random. Often, you expect one thing to happen, and what you get is something else altogether. But since it's such a hot question, I decided to (bravely) venture into giving you a reasonable, non-speculative answer to it. 

First off...and this is where most investors get it wrong...is valuations. Market returns from any given point are inextricably linked to the valuations you buy at. Now, financial jargon is enough to scare off even the bravest of souls, but please bear with me. It's actually pretty simple... 

All 'valuations' refers to is the price of a stock relative to the underlying business's profits or assets. So if a stock is trading at Rs 200 and the business's net worth represented by that stock is Rs 100, that's a valuation of two times (2x) net worth. We can do a similar calculation for the stock price relative to the profits of the business. 

What are the market's valuations right now? Well, relative to net worth, the average large company's stock (represented by the BSE Sensex) is trading at about three times (3x) the underlying business's net worth. 

So the question, more wisely framed, would be 'What Returns Will the Stock Market Give if One Buys at Current Valuations?' 

Now, as they say, history doesn't repeat itself, but it certainly rhymes. So I did some serious number crunching. I went all the way back to 1990 to look at the entire twenty-six years of stock market history since then. After all, the bigger the sample size, the stronger the conclusions from the data. 

What I was looking for, of course, were past valuations similar to those prevailing now. That is, I wanted to see at what different points the BSE Sensex was trading at about three times net worth. Then, more importantly, I wanted to see the kind of returns the market gave over the next five years. 

And here's the answer:

Date	Next 5 Year's Returns (point-to-point)
25-Mar-91	180%
14-Nov-95	26%
12-Jun-97	-16%
09-Jun-99	22%
20-Dec-00	130%
28-Nov-03	79%
10-Jun-04	206%
13-Oct-08	82%
11-May-09	97%
Average	90%

Data Source: Equitymaster, Ace Equity

Now, is an average return of 90% over a five-year period good? Let's see what these returns look like on an annual compounded basis to get a better idea:

So there it is. 

Over the last twenty-six years, each time the markets have traded at valuations of around 3x (as they are today) they have gone on to give annual returns ranging from -3% to 25% over the next five years. On average, they've given returns of 12.3%. Add in dividends of 1% to 2%, and you end up with an average of 13% to 14%. 

But this doesn't solve one important problem. That is what you can expect...on average. But with this kind of volatility in returns even over a five-year period, what if you end up with a sour patch? What if you get an episode of -3% returns, rather than one of the better ones? 

Well, one of the reasons for these volatile results is the current market level. Though not exorbitant, valuations of three times net worth can't really be called cheap either. When market valuations are lower, the probability of a bad five-year patch goes down significantly. 

Nonetheless, that's where we are today. 

Happy Investing

Source:Equitymaster.com