Sensex returns are mean reverting globally, equities are known to mean revert. Thus, prolonged periods of superior equity returns are followed by periods of mediocre returns and vice versa.
Exhibit 1 emphasises this dynamic in the context of Sensex returns—a rolling five-year return plot for the Sensex suggests that Sensex returns mean revert over long periods.
Since over the past six months we have just started rising from the zero line, there seems to be a reasonably high likelihood that the recent period of sub-par returns could be followed by a period of superior returns. But what drives Sensex returns?
Whilst Sensex returns mirror EPS growth over longer periods...
...over any timeframe, Sensex return has two parts to it: change in PE and EPS growth Since 1991 both Sensex returns and EPS CAGR (earnings per share, compund annual growth rate) have been nearly same at roughly 14%......but an R-square of close to zero suggests there is no correlation between the two on a y-o-y basis. (Exhibits 2 &3) PE matters more than EPS over shorter timeframes Whilst over long time periods (say, over a decade or more), Sensex returns mirror earnings growth, over shorter timeframes (like on y-o-y basis), PE is a bigger driver of index returns than earnings growth.
What has driven the Sensex’s PE?
Short-term rates, the slope of the yield curve, US bond yields and gross fixed capital formation (GFCF) growth seem to affect the Sensex’s PE. GDP growth and earnings growth on the other hand do not seem to materially impact PE.
Whilst most of these factors seem to be at inflection points currently, they have not as yet staged a meaningful turnaround (barring US bond yields).
What has driven the Sensex’s EPS?
Monetary easing, rising US bond yields, higher GFCF growth and higher GDP growth seem to affect the Sensex’s EPS favourably. On the other hand, high levels of inflation seem to impact it negatively.
Given that Ambit’s Economy team expects a muted recovery in FY15 with persistent inflation and hawkish monetary policy, we expect our current bottom-up Sensex EPS estimate of 1,530 to be downgraded.
Our prognosis for the Sensex in the year ahead. We see no major PE rerating for the Sensex but earnings growth should lift the index to 24,000 (16% upside from current levels) by March 2015.
Portfolio strategy We retain our ‘quality at a reasonable price’ (QARP) approach to portfolio construction as the reversion in the following polarisations would continue: