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The link between GDP growth and the broad market index

The link between GDP growth and the broad market index
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First Published: Tue, Feb 15 2011. 09 53 PM IST
Updated: Tue, Feb 15 2011. 09 53 PM IST
As I breezily recommend an index fund to anybody who is risk averse and still wants “better” return than a bank deposit, I forget to take into account a slice of the reader and viewer segment which does not know the assumptions or the formulae behind this sweeping prediction of the future that I like to make: Indian equity will give an average return of about 15%, year-on-year (y-o-y), over the next 10-15 years. You’ve heard this statement over and over again so often that it almost seems like a basic rule. But it takes a vigilant reader of the paper to ask the obvious question: what is the basis of this statement and if past returns do not guarantee future returns, how can we predict what the markets will do in the next few years? Writes Anantha Padmanabhan from Bangalore: “Today the economy is booming, however, over the next 15-20 years is it feasible to have such a year-on-year growth of the Sensex (and thus the economy)? Historical data over the last 15 years is fine, but going forward I am a little sceptical. What makes us say that the markets will give a 15% year-on-year return over the next 20 years?”
The causation assumed by the reader (markets will cause economic growth) is actually the opposite—it is the rate of growth of the gross domestic product (GDP) that gives us a handle on what the market return is likely to be. GDP growth will come from increased business activity in the country and that metric is captured by a market index like the Sensex or the Nifty. These indices account for about two-fifths of the market cap of all the listed companies and a broader index like the BSE 200 makes for about 80% of the total market cap. Though there are dissenting voices on the link between GDP growth and market return, the linkage is a well-used handle to make broad predictions on the market by career investors such as Warren Buffett. So what does this very rough rule of thumb say? It says that real GDP growth plus inflation plus dividend yield should give the average annual rate of return of the broad market index. Roughly. Or if GDP grows at 8%, inflation is at 6% and dividend yield at 3%, then the broad market index (like the Sensex or the Nifty) should grow at 8+6+3 or 17% y-o-y.
Let’s back test it for India. Let’s take the last two decades, from 1990 to 2010. We see that GDP grew at about 6.5%, inflation was at an average of 7% and dividend yield about 1.5%. Add the three and we get a total of 15%. The Sensex grew 17% y-o-y over the period. Remember, this is rough number crunching and the figures are approximations—we’re looking at large handles rather than technical correctness down to the fourth decimal point. A person who had invested over this 20-year period saw his Rs1 lakh invested in the index grow to Rs23 lakh. And that is what the reader is asking; what makes us think that this superb performance will have an encore? Will we ever get this opportunity again to grow our money by simply investing it in some fund?
The answer to this question lies in our prediction of what lies ahead for India. If we grow at an average of 9% a year for the next 20 years, with inflation at 7% (likely to be higher due to the demand push and supply bottlenecks that will push and push prices) and dividend yield remaining at 1.5%, we get a forward growth of 17.5% y-o-y. So Rs1 lakh invested today should, in 20 years, throw back Rs25 lakh. That is, if we choose an index fund. Choose a managed fund that delivers (like some that have over the past 12-15 years, giving more than 20% y-o-y) and you could do even better. Your view of how India will grow in the next 20 years will determine how you will invest in the stock market. If you think that all that has to be built is still to happen and that the twin pressures of subsistence millions becoming middle class and the middle class becoming urban mass affluent will cause a continuing demand push for goods and services, then you should sit back, relax and allow the index to continue its journey. The lazy investor buys the index and the one who can do a bit of research, buys managed funds to pick those that can beat the index.
Monika Halan works in the area of financial literacy and financial intermediation policy and is a certified financial planner. She is editor, Mint Money and can be reached at expenseaccount@livemint.com
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First Published: Tue, Feb 15 2011. 09 53 PM IST