Sensex could touch 70,000 by 2020 — here’s why

Equity markets in India rose to their previous peak of over 21,000 after Diwali, and then corrected sharply to about 17,500 by mid-February.

After a couple of sharp upward movements  and downward movements of close to 1,000 points, the Sensex  has been moving up since late March to reach about 19500 points currently.
The question that is uppermost in the minds of most market participants is - where is the market headed from here?

Which begs another one: if the market is expected to rise, then what is the time horizon over which it will play out? It’s important because it is difficult to predict the short term; unlike long-term trends, the short-term is not always driven by fundamentals.

This study is an attempt to answer that through a logical analysis of the historical correlations in the behaviour of India’s gross domestic product (GDP), the Bombay Stock Exchange Sensex and corporate earnings.

GDP in India is projected to grow by 3.4 times to about $4.6 trillion by 2020. There may be many factors — oil prices, interest rates, foreign exchange rates, inflation, the global macroeconomic situation and event risks such as wars and so on — that could spoil the party.

These are outside the scope of this analysis.

This article simply tries to answer a straightforward question:  where could the Sensex be, if GDP reached $4.6 trillion by 2020?

The answer is 70000. It may sound out of whack today, but an extrapolation of past market behaviour shows this is very much a possibility. Of course, there will be several crises and hiccups — both domestic and international — along the way, that will take the index down. But once the events are absorbed, fundamentals will stand up.

70000 translates into a compounded annual growth rate of 14% for the Sensex over the next 10 years, and makes the Indian equity market a compelling asset class.

Methodology
The accompanying chart juxtaposes trends in India’s GDP, corporate earnings, the Sensex and the price earnings ratio (PE) between 1995 and 2010.
During this period, the GDP has grown 5.2 times; corporate earnings 8.8 times (ignoring 1995, which saw very low earnings); and the Sensex 6.5 times.
It is clear that markets have been buoyed by healthy corporate earnings and GDP growth. In fact, they have grown at a slower rate than earnings.

The PE multiple during much of this period has hovered in the 15-20 range. It does not show any marked change between the period immediately preceding 2003 (when the Sensex started rising sharply) and the post-2003 era, which goes to show again that the rise in the Sensex was largely driven by earnings, and not by increasing multiples.

Interestingly, the index as well as corporate earnings moved in tandem till 2007-08, at which point they moved in opposite directions. The Sensex plunged immediately after the credit crisis struck, a year ahead of the earnings decline.

The previous peaks for the PE multiple were in 1995 (23.6), 2000 (24.5) and 2007 (22.3). The multiple for Sensex is currently about 20. But the economy has grown during this time. Therefore, the current high multiple is backed by a five times larger economy compared with the one in 1995, three times compared with 2000 and nearly a third larger compared with 2007. Meaning, the current high multiples are rooted much stronger compared with the past.

Now, point to point comparisons could be tricky. For example, if one took 2008 as the end point, the multiples would be very different. However, 2008 appears be more of an outlier to the trend.

The US experience
It is always helpful to study the experience of other countries that have been in similar situations in the past. Between 1980 and 2010, American GDP grew around five times — from roughly $3 trillion to about $14 trillion.

During the same period, the Dow Jones stock index grew 10 times, from about 1,000 to over 11,000 (ignoring 14,000 in early 2007 and 6547 in March 2009) implying that the stock index multiplied twice as fast as GDP.

Crystal ball-gazing
A recently published research paper by Crisil, the rating agency says India’s GDP is expected to grow to about $4.6 trillion by 2020.
What does this mean for the Sensex? As we saw, the US stock index multiplied twice as fast as GDP over the last 30 years. In India, over the last 15 years, the Sensex multiplied at 1.3 times the GDP multiplier rate.

Two sets of arguments can be made here. One, earnings and the Sensex’s growth vis-à-vis the GDP will be slower than in the past because of:
1.    the base effect - the base is higher now than in the past;
2.    and, more severe domestic and international competition in future.
On the other hand, this growth will be faster because:
1.    infrastructure will be better in future compared with the past;
2.    demographics will increasingly become better;
3.    more foreign funds will flow into India;
4.    and, because of increased productivity brought about by technology.
So, even if the Sensex moves just at the rate of GDP growth - and not faster- it will touch 70,000 by 2020.

— Thyagarajan is CEO of Carnation Consulting and a former director of ratings at Crisil