The Hindu Business Line : Will boom continue or is correction due?

WITH the bourses on fire, the question that is uppermost in the minds of investors and other market participants is whether the capital market values are too high and, therefore, due for a correction.

Mr Prashant Jain, Chief Investment Officer of HDFC Asset Management Company Ltd, has an interesting take on this question.

He points out that, over the last four years, the BSE index crossed 6000 twice - once in 2000 and again in 2003 - and that, each time, it corrected. Now that the Sensex has crossed 6000 again, some investors/market participants are extrapolating from their previous experience and concluding that the markets are too high now and that the index is due for a correction.

While it is extremely hard to forecast the short-term movements of markets, he says, the expectation that the index will repeat the movements of the past "is not logical and is, in fact, erroneous."

Mr Jain's contention is based on the premise that, over long periods of time, index returns have to be nearly equal to the profit growth rates of the companies that comprise the index. If this does not hold true, then the P/E multiples will either start approaching infinity/very high levels (if the index continues to grow at a rate faster than the profit growth rates) or P/E multiples will approach zero/very low levels (if the index returns continue to lag the profit growth rates). As neither very high P/E multiples nor very low P/E multiples are likely to sustain, index returns end up tracking profit growth rates over long periods of time.

"If one looks at the present situation, the returns from equity indices have lagged profit growth rates for long. In fact, the Sensex has delivered just about 4 per cent per annum (CAGR) returns over the last 10 years and about 6 per cent per annum (CAGR) returns over the last 5 years. These returns are significantly below the profit growth rates, which are 21.5 per cent (CAGR) over the last 10 years and 22.6 per cent (CAGR) over the last 5 years. This is also reflected in the low P/E multiples of the Indian equities.

"The implications of this are simple. Whereas, it is very difficult to forecast movement of indices, as per this reasoning, it is reasonable to expect the index to perform either in line with the profit growth or to grow at a faster pace (the present P/Es leave room for an expansion and are currently ruling below their long-term average). The present PE is 14x 2005 and 12.2x 2006 vis-à-vis the 5-year average of 14.9x and the 10-year long-term average of 14.6x."

Another point worth noting, he adds, is that a majority of mutual fund schemes have done significantly better than the markets in general, particularly over long periods of time.

For, example nearly all of our equity funds have delivered returns that are between 15 per cent per annum and 25 per cent per annum (CAGR) over the last 5 to 10 years - significantly higher than the markets. Returns over last one and 3 years are even higher, but these are not representative of long-term returns from equities. Of course, past performance may or may not be sustained in the future.

Mr Jain argues that it is incorrect on the part of investors to focus on the absolute index and to conclude that it is too high.

"This is wrong as the index will, with time, keep on growing to keep pace with the growth of economy and of companies. The index of 6000 today is much cheaper than the index of 6000 in year 2000 as profits have nearly doubled over last four years. In fact it is reasonable to expect the index to cross 8000 and then 10,000 (these numbers are mentioned just for illustration and do not have significance otherwise) and then be at even higher levels with time to keep pace with the growth in economy and in corporate profits. After all, the same index was below 1000 in 1990... "

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