Reversion to the mean is said to be the thumb rule of
financial markets, according to legendary John C Bogle. It is indeed a powerful concept in stock markets. In case returns are extraordinary for one year, the probability of getting similar high returns in subsequent years is low. And vice versa. In other words, over the long term, returns tend to move towards long-term averages.
Long-term stock market returns are driven by
earnings growth. Data analysed for last two decades shows Nifty returns do mirror
EPS growth. The key findings of the analysis are:-
- Over last 20 years, Nifty returns were 11% per cent while Nifty EPS grew at 10 per cent per annum. Interestingly, India’s nominal GDP grew at 12 per cent per annum during this period. Nifty EPS growth has not kept pace with nominal GDP growth, whereas conventional wisdom would have advocated otherwise.
- Good times ended in 2007 at the peak of the previous bull market. That’s why many of us did not get the feeling of good times when Nifty made a new high.
- Bulk of the returns were made between 2002 and 2007, when India hit headlines with India Shining to becoming part of Goldman Sachs’s BRIC nations. These days, BRICS and 2020 projections are not to be heard.
- From 2007 to 2020, Nifty returns stood at 3 per cent per annum. Domestic investors would have made more money simply investing in a G-Sec fund.
- Stock pickers made merry as many stocks gave phenomenal returns, but market averages tell a different story.
- The 2010-20 decade was a lost one for India, especially post 2016. Demonetisation, GST rollout, NBFC crisis, Covid pandemic and border disputes with China were among the headwinds. Even prolific Hindi movie script writers could not have thought of the hero (India’s GDP) getting battered by a constant barrage of problems – one after another.
Where is the silver lining in the dark clouds?
The answer not surprisingly is in the reversion to the mean. Go back in time and relive the 2001-03 period. We had Ketan Parekh scam, dot com burst, Enron, SARS and the twin towers tragedy. Despite all these challenges, the 2002-2007 period was a blockbuster one for the stock market.
FY21 will be even worse, given the projected GDP contraction. It will be fair to expect Nifty EPS to decline faster and stay in the Rs 400-440 range. When analysts’ conversations point towards Nifty P/E being high, those hide the fact that earnings are depressed a bit too much.
This century had one decade of good earnings followed by one lost decade so far. The odds are high that normalcy will come back in FY22 and EPS growth can go back to the 10 per cent range. If God is kind, we can grow faster in the new decade; a possibility most people have written off for now.
My conclusion: Use the current crisis to your advantage and put money to work. Increase your equity allocation this year. And like Rip Van Winkle, if you go to sleep and wake up in 2025, chances are a pleasant portfolio growth surprise will greet you.
One word of caution – Morgan Housel puts it very nicely – knowing that there will be a reversion to mean does not mean you know when things will revert. Hence, put only that much money in
Indian stocks that you can afford to forget till 2025.
(R Venkataraman is MD of IIFL Securities. Views are his own)