I am no finance expert. I mostly learnt a few things on my own by reading a few books. So when you read this blog, remember this is not investment advice
The Indian stock markets have been on a tear recently. In fact the NiftySmallCap Index is at an all time high even as the benchmark indices Nifty50 and BSE Sensex are at all time highs. This is in stark contrast to prevailing news media coverage of suffering due to covid19. The NiftySmallCap250 Index was at its all time high level of 7568 last seen in Jan 2018. Many could argue that the small cap companies were extremely frothy around that time. After a correction of almost 60% (!!) from the peak, the index recently, during these times of Covid19, the index has passed the earlier and is now at 8000. Whenever Small Caps go up, my experience suggests that retail investors have started to load into them. Typically, this has been a decent predictor of market tops.
The news media job is to report facts on ground and there is no doubt of immense suffering due to Covid-19 at individual family level as well as entire country level. People are sick, at the peak of the crisis, hospital beds were unavailable, key medicines were unavailable and surely many deaths have happened. I for one would argue that most numbers are under reported and many more families may be bearing the brunt of the pandemic.
During times like these when most of the nation is at home due to various versions of curfew imposed across the country, it would seem difficult and possibly insensitive to our people that finance folks are rejoicing and making money. What explains this?
Is it possible that markets are frothy and hence we are poised for a downward draft? Amongst my family members and a few friends, many consider me to be better in world of finance than them (!) and seek advice if they should sell their stocks or if now is the time to do SIP vs lump-sum investments considering “unbelievable” index levels.
I am bullish on Indian stocks from here. In general I am bullish (I think that must be part of make up of any person investing in stocks; having hopes and thinking of a better future). I do expect Indian stocks to continue to go up from here.
Forecasting is tough but I will go out on a limb and claim that next 10years stocks returns will average ~12% p.a from here.
To build a forecasting model, I use the data available at niftyindices.com on PE/PB/Dividend Yield as against the total returns. We shall use Nifty500 for our reference here.
Just using the Book to Price Ratio (inverse of Price to Book Ratio), we see that it has pretty decent forecasting power . The R2 =0.72. We can try with the other ratios as well.
Quite clearly the BP ratio has the best explanatory power but others also do provide some evidence that current valuations can predict future returns.
Assuming we can stretch it and run a regression to fit the models, we arrive at a simplistic model as follows:
Future 10Y Nifty500 Yield = 0.0751 + -1.55455 * EP + 0.210854 * BP + 4.840427 * DP
This gives us a model fit of ~82%.
The past is never a predictor of future but the t-stats of the coefficients run in the regression tell us that we can have some confidence.This is effectively based on only 10 years of data. So it can be woefully data deficient and will need many more years to further (in)validate the model
How has this forcefully fit question worked to predict the returns in the past?
Above graph is difference in actual returns vs forecast returns over 10Y. Positive number means, model has forecast it on the lower end whereas a negative number means the model has predicted higher returns than actually realized. Note that data ends in May 2011 as returns data post that will be realized hereon.
As can be seen, the difference between realized vs forecast returns is pretty wide of -6% to 4%. Let us use these limits as our boundary ranges and see what we can expect.
Using current valuation levels, model predicts future returns = ~12%. Instead of a point estimate, let us add the known issues of how bad the model can be and we are at 6%-16% from here to May 2031.
Given that currently GILT will yield ~6%, the lower end of the future returns being 6% seems like a good bet (at least for me).
P.S: I am not stock researcher/finance expert. Stocks are very risky assets and I may be 100% wrong in my forecasts.This blog is more a diary for me rather than investment advice. Please speak to your advisor before doing anything.