Nifty unlikely to deliver positive returns for two years

An interesting "top-down" approach to assessing the likely long-term return from the Nifty would be as follows. The economy is expected to grow at between 7 per cent to 7.5 per cent of GDP in real terms in 2018-19. Inflation is expected to run at about 5 per cent to 5.5 per cent. That means nominal GDP growth will be about 12.5 per cent.

Equity earnings normally grow at a premium over nominal GDP growth. This premium is assumed to be around 3 per cent or so in India over the long-term. If we add that, EPS growth should average around 15.5 per cent, or, perhaps, 16 per cent for the Nifty basket over the next three years. 

Obviously, this is an optimistic target. At least two heavyweight sectors banking and information technology, will not grow at that rate in 2018-19 at the least. But on the other hand, cyclical sectors like metals, automobiles and cement could grow quicker than 16 per cent if there is a consumption rebound.

So, let us assume 15-16 per cent EPS growth is a reasonable expectation over the period 2018-2021. Valuation for this growth rate would be theoretically reasonable at 15-16 PE (with a PEG ratio of one). Historically however, the long-term average (mean) price-earnings (PE) and the median PE are both in the 18-19 PE range. That is over-valuation in theory but acceptable in practice, given historical performance. 

So, this rough calculation tells us the Nifty earnings can be expected to grow at 16 per cent and it could be discounted at a historically sustainable PE of 19-20. At this instant, the Nifty PE (last four quarters weighted by free float) is around 25 with the index held at around 10,500.  

That is still extreme over-valuation despite the post-Budget correction. If we calculate 15-16 per cent EPS growth coupled with a lower PE discount of 19-20, we are looking at a likely correction of 10-12 per cent from current levels. That would imply a valuation of something like 9,400 Nifty sometime before the end of 2018-19. 
 

Next, let us project forward into 2019-2020. Assume the Nifty will continue to see EPS grow at 15-16 per cent and also sustain a PE discount of 19-20. If that is the case, positions taken at current values (about 10,500) would start breaking even two years later. If this pattern of 16 per cent growth and 19-20 PE discount holds into 2020-21, the returns will be positive at around 7-8 per cent compounded.

This may seem like a theoretical exercise. Markets rarely hit fair value. But, it does provide a useful basis for creating investment strategies. First, it tells us that, given growth and discount assumptions that seem to be historically reasonable, positions taken at the current Nifty valuations may take two-three years to yield decent returns. Second, it offers a “fair value” of Nifty 9,400. Below that, the Nifty looks attractive. 

A long-term investor can build this into an investment strategy that uses 9,400 as a pivot. Above 9,400, hold positions and maintain ongoing SIPs. Do not increase equity exposure. Below 9,400, increase equity exposure.

If the market drops significantly below 9,400, say, by another 1,000 points, increase equity exposures by a lot. The internal rate of return for investments made at Nifty 8,500 (if the index does hit those levels) would be very good.

How likely is a correction till 8,500 or lower? Reasonably high. We have election-related volatility on the cards for the next 15 months. That could trigger big crashes. The Nifty has often corrected by over 20 per cent from peak values (that would be 8,900, given the recent peak of 11,170) and it has corrected by over 50 per cent from peak values several times as well.