Investing is not an art or a science. If it was a science the current complex algorithms & huge computing power could sustain-ably outperform the market (Read “When Genius Failed”, A wonderful piece of financial history https://amzn.to/2Y7xj8a). Now, if you think that it is an art and abstract than look at all the wonderful research pieces of Dr Eugene Fama, who would be able to express the complex problems of finance in terms of hypothesis to prove with data. Thankfully the father of indexing John Bogle has simplified in his explanation of Market Returns using the below for us commoners.
Market Value = (P/E) x Earnings,
Hence Markets Returns = Change in P/E + Change in Earnings
As per his assertion, the fundamental factor of the market returns is driven by the earnings growth (decline) over the long-time horizon. The market returns will be driven mostly by this factor in high correlation. Though in short runs, the investor behavior will change/ swing between greed & fear, hence the multiple to earnings he will pay also changes. On a long-term basis this will tend to revert to mean. This simple explanation is quite useful to understand the behavior of markets and gauge the possible returns in future. There is one problem that the mean of the P/E also evolves over the period of time so how to know if the market P/E multiples are returning to mean or not.
In my view, level of (P/E) is determined based on two factors:
- The level of interest rates prevailing in the market, if the interest rates goes down more people shift towards riskier assets to generate extra returns and bring up the level of (P/E) in markets. You can read more about this relationship at Importance of PE ratios!. The chart below shows that the mean P/E is averaging higher over the last 2 decades or so. (From 15 to 23 on the trend line.)
- The sentiment of the investor, if they have bullish sentiment, they will agree to pay the higher multiple for same level of earnings vs during the bearish sentiment
How does it help us gauge the future return possibility of the markets?
As I mentioned this simple expression can help us understand the future market behavior with some probabilistic output and help us determine our portfolio positioning. The three parameters, I have to estimate are below, on that basis we will create a metrics of possible future returns.
- Future earnings growth: Over the last few quarters, the earning growth has been closer to 10% on yearly basis. Who knows if that will swing up drastically given the continuous slowdown in the GDP numbers/ other indicators. Even though the recovery of bad loans can bring some cheer on the earnings front. You can think of your probabilities accordingly
- Futures changes in the policy interest rates: RBI has been front running the rate cycle by cutting the interest rates in expectation of the economic slowdown. So far in the year, we have already seen cut of interest rate of 135bps almost. Will it go beyond one more rate cut ?? If not then it means the P/E expansion should stop from here??
- Sentiment of the market: The economic slowdown related news and muted earnings growth is not helping the sentiment of an investor. Specially the ones whose portfolio is bleeding due to larger exposure towards Mid/Small caps. This again can be split between the Foreign & domestic investors but is difficult to gauge in general.
Based on these three expectations you can get to a 2 scale metrics like below.
As in above scenario there is higher probability of correction in P/E and lower earnings growth; the possible return metrics range from -14% with 7.5% probability (5% x 15%) to + 30% returns with 1% probability (5% x 2%). You can have different probability estimates based on your view on the market and so should your expected return. In above scenario, the mean expected return comes out to be 2.4% due to this Should you prefer to be on the defensive stance on the equity allocations?
If you are interested to see how these calculation works, then write to me and I am happy to share the excel version to you. You can input your expected probabilities & determine possible return scenarios for yourself.
Till then Happy & Safe investing!!