Crystal gazing

SMARTSHARE

Economists refer to the "trend rate" of GDP, which can be defined as the sustainable average rate at which an economy can grow if major macro-economic variables aren't afflicted by Parkinson's disease.

The assumption is that the GDP growth rate is a mean-reverting variable. Given no massive changes in macro-economic fundamentals, GDP growth shows a "central tendency"; a movement towards the trend from either above or below that mark.

Stockmarket returns also have long-term trend rates, which can be represented by the compounded annual rate of growth (CARG) of a benchmark index. It's less clear whether this is mean-reverting though most people intuitively believe it is.

The Sensex was introduced as a weighted-average of 30 stocks with a base value of 100 in 1979-80. In the following 25 years, the constituents of the Sensex have changed many times but the index has moved up to its current levels of 9400.

The CARG for the last 25 years is around 20 per cent, which is truly impressive. Further, this neglects the dividend yield of the Sensex basket.

Sensex dividends have often been worth well over 2 per cent of the basket's value and rarely below 1.5 per cent. A basic knowledge of compound interest shows how much that boost returns over a quarter-century.

Let's assume that 20 per cent is the long-trend rate of Sensex return. Now take a look at the past five years. In December 2000, the index was trading at 3970 - in the past five years, it's registered a CARG of 18.8 per cent.

Call that the short-term trend rate, or more impressively, the 21st century trend rate. The 1 per cent drop from the long-term trend rate can be explained easily - we'll deal with that later.

In calendar 2003 (actually between December 2002- December 2003), in calendar 2004 (December 2003-Dec 2004) and calendar 2005 (Dec 2004-Dec 2005), the Sensex has returned 72 per cent, 13 per cent and 41 per cent respectively. The 3-year CARG appears to be 40 per cent plus.

That's way, way, over the long-term or 5-year CARG. If there is a reversion to the mean in 2006, it means a correction of somewhere between 10-20 per cent. A paper-napkin calculation suggests that a December 2006 Sensex value of 7800-8400 will still maintain the long-term or five-year trend.

Why has the five-year CARG dropped in comparison to the long-term CARG? The easiest explanation is the sharp reduction in interest rates. Equity returns offer a premium over the risk-free return so it's explicitly linked to the interest rate.

Given that short-term rates have fallen from over 16 per cent to below 5 per cent in the last five years, we could argue that the equity premium has actually increased.

A lot. Now there are some interesting points to ponder in the context of 2006. Will the Sensex revert to a mean in 2006 with the correction that implies? If so, we could argue that there's been no major change in market fundamentals.

If equity continues to soar, one will begin to wonder if there has indeed been a major macro-economic inflection in the past three years. The optimists hold the view that the 3-year CARG is 40 per cent because there has truly been such an inflection.

My two paisa worth is that a 40 per cent CARG of equity return with an inflation rate of 6-7 per cent is difficult to justify unless GDP is growing at 15 per cent-plus. So I guess I'm pessimistic about overall market prospects in 2006.