Will the bull run continue?

The Sensex has recovered somewhat after the fall of nearly 7% last week. It has had a dream run since 1999 producing an annualised return of 23.7%. Will this continue? Many think it will. Swaminathan Aiyar, writing in the Times of India, argues that nominal GDP will grow at around 12.5%. Profits of the better companies will grow at at least 1.5 times nominal GDP. So the Sensex can be expected to grow at 18% in the next years and touch 30,000 whatever the intervening ups and downs.

Is this plausible? I see several problems in Aiyar's formulation. First, sales of top companies may grow faster than GDP but not necessarily profits.

Secondly, earnings growth in recent years are, to some extent, the result of savings in costs, including interest costs. These savings are not entirely sustainable. Besides, there will be earnings dilution arising from funds raised for capital expenditure.

Thirdly, in projecting a Sensex level of 30,000, Aiyar assumes that the current level is right. The P/E for the Sensex is around 24, way above its historical level.

In short, projecting an 18% annual rise in the Sensex from today's level appears unrealistic.

There is also the issue of what sort of returns we can expect from the equity market in the long run. The long-run premium in the US is 5.8%. For the world as a whole, it is 4.9% (based on an index of 16 developed country markets). That is the historical premium. An academic study (which I cite in my recent ET column) projects the future premium at 3%.

If we assume that returns in India over a long period of 20 years (the past seven years plus another 13 years)will approximate returns to a global index, we can most likely expect an annual return of 10% (assuming a 3% risk premium on a risk-free return of 7%). This return, according to the study I cite, has a probability of 50%

There is, of course, a chance that the coming decade will be a unique period of exceptionally high returns in the Indian market. But, going by a study on world-wide stock market returns, the probability that the annual return of 23.7% seen in the past seven years will be sustained is just 10%. There are no miracles in the stock market, you see.

I explore this theme in greater detail in my latest ET column.