Corporate earnings are increasingly getting sensitive to growth rates of the economy in India. A 22-year study of GDP growth rates and Sensex company earnings shows that on an average, Sensex earnings have grown at 2.2 times that of the economic growth rate. In the past decade, the influence has also been more consistent.

In the financial year 2010-11, when the Indian GDP grew at a rate of 8.5%, Sensex earnings grew by about 12.1%, or 1.4 times GDP growth rates. The rate of Sensex earnings growth is important from the context of equity returns, since over the long term, market returns only chase earnings growth.

Higher component of industry and services in GDP has been one of the main reasons for corporate earnings moving in sync with equity markets. In the past, agriculture constituted 25-30% of GDP which in turn led to disparate set of growth rates for corporate earnings as well as GDP. But over the years, the component of agriculture in overall GDP has fallen to 16%, while services and industry comprise 55% and 29% respectively.

Secondly, the weightage of companies with commodity businesses has increased in Sensex and currently comprises 25-30% of overall Sensex earnings. Businesses of these companies are cyclical and often their profits move sharply up or down along with growth rates of the economy. Metal, oil and gas as well as cement companies are among them, whose earnings vacillate more than others to growth rates of economy.

In the past, it has been that a GDP growth rate of below 7% had applied brakes to earnings growth rates of Indian corporate. In fact, for the financial year 2008-09, when GDP grew at a paltry 6.7%, Sensex earnings fell 8.6%. Similar fall in earnings was seen in financial years 2000-01, 1999-2000 as well as 1993-94.

Also interestingly, Sensex earnings have often grown at faster clip than ever whenever there is an economic recovery. So in financial years 2003-04 and 2004-05, earnings growth rate of Sensex companies were at 3.6 times and 5.1 times of their respective GDP growth rates, which later petered out to 2 times. Historically speaking, the best investment phase is when economy is recovering.

At this juncture, when GDP growth rates expectations for 2011-12 are getting lowered by economists on fears of inflation and higher interest, it goes without saying that Sensex earnings is bound to grow at lower rates.

The market estimates put earnings growth at 24%, which is about 3 times of expected GDP growth rates.

As an investor, it seems the best strategy to adopt is by investing long-term to capture the various return giving phases. That way one is sure to capture the supernormal returns that are associated with markets in the initial phase of recovery. If one were to expect even a 7% annual growth in GDP over the next decade, we are looking at 15.4% earnings growth for Sensex on an annual basis, based on the historical trend. Market returns should give 15% annually while Sensex hovers atleast upwards of 60,000 by 2021.