/If you believe in reversion to mean, put your long-term money in stocks

If you believe in reversion to mean, put your long-term money in stocks

Reversion to mean is said to be the iron rule of financial markets, according to the legendary John C Bogle. It is a powerful concept indeed in stock markets. In case the returns are extraordinary for one year, the probability of getting similar high returns in subsequent years is low. And vice versa.

In other words, over the long term, returns tend to move towards long-term averages. Long-term stock market returns are driven by earnings growth. An analysis of data for last two decades shows Nifty returns mirror EPS growth.

The key findings are

  • Over last 20 years, Nifty returns have been 11 per cent per annum while Nifty EPS grew at 10 per cent per annum. Interestingly, India’s nominal GDP grew at 12 per cent per annum. Nifty EPS growth has not kept pace with nominal GDP growth, whereas conventional wisdom would have advocated otherwise.
  • Good times ended in 2007 at the peak of the previous bull market. That’s why many of us do not get the feeling of good times even when Nifty made a new high. But that’s another topic.
  • Bulk of the returns were made between 2002 and 2007, when India hit headlines with India Shining becoming a part of Goldman Sachs’s BRIC nations. These days BRICS and 2020 projections are not to be heard.
  • From 2007 to 2020, Nifty returns were 3 per cent per annum. Domestic investors would have made more money by simply investing in a G Sec fund.
  • Stock pickers made merry as many stocks have given phenomenal returns but we are looking at market averages.
  • The 2010 decade was a lost decade for India, especially post 2016. Demonetisation, GST, NBFC crisis, Covid pandemic and border disputes with China were among the headwinds. Even prolific Hindi movie script writers could not have thought of the hero (India’s GDP) getting battered by waves of problems – one after another.

Where is the silver lining in these dark clouds?

The answer, not surprisingly, is in the reversion to mean theory. Go back in time and relive the 2001-03 years. We had Ketan Parekh scam, dotcom burst, Enron, SARS and the Twin Towers tragedy. Despite all these challenges, the 2002-2007 was a blockbuster period.

FY21 will be even worse, given the projected GDP contraction. It will be fair to expect Nifty EPS to decline faster and stay in the Rs 400- 440 range. When analysts’ conversations point to Nifty PE being high, it hides the fact that earnings are depressed a bit too much.

This century had one decade of good earnings followed by one lost decade. The odds are high that normalcy will come back in FY22 and EPS growth can go back to the 10 per cent range. If God is kind, we can grow even faster this decade; a possibility most people have written off for now.

That makes case for using the present crisis to your advantage and put money to work. Increase your equities allocation this year. And like Rip Van Winkle, if you go to sleep and wake up in 2025, chances are a pleasant portfolio growth surprise will greet you.

One word of caution – Morgan Housel puts it very nicely – knowing there is a reversion to mean does not mean you know when things will revert. Hence, put only that much money in Indian stocks that you can afford to forget till 2025.

(R Venkataraman is MD of IIFL Securities. Views are his own)

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