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Suresh Krishnamurthy

IT DID not stop at 3,300 nor at 3,400 and is now tantalisingly poised at 3,499. Where is it headed? Further north? Maybe. However, in contrast to earlier bull runs, a Sensex rally to previous highs such as 4,700 or possibly even 4,000 appears unlikely within the next six months.

That is because expected returns from most classes of investments have declined in the last few years. If asset prices rise, in spite of this decline, then the returns will come down proportionately.

Premium returns: The returns from the debt market set the tone for what to expect from the equity market. The expected return from equities is a function of the returns from a risk-free debt security.

The 10-year government security is now yielding about 5.75 per cent. The premium that equities can earn above this level of 5.75 per cent is usually not expected to be very high.

In the US, equity risk premium is a subject of great debate. However, most agree that it has been between 4.5 and 5.5 per cent in the past.In India, stocks may well earn much higher.

However, even if the expected returns are as high as 15 per cent, then stock prices can only double in five years. That is, if Sensex started 2003 at 2,900, it can be expected to touch 5,800 only by 2008.

Factoring yield crash: There is, however, one factor to be discounted. Yields from debt instruments have come crashing down from over 10 per cent to below 6 per cent. Stock prices have to rise to factor in this development.

For example, the price of the 9.81 per cent government security has risen from its issue price of Rs 100 to the level of Rs 130. The expected return of 5.75 per cent is when the price is at a level of Rs 130.

Similarly, equity prices have to initially rise from say Rs 100 to Rs 125 to factor in this yield crash. From Rs 125, the returns will not be more than, say, 15 per cent per annum for stocks.

It is difficult to categorically state if this adjustment — rise in price from Rs 100 to Rs 125 — has already happened in the equities market. However, the prices to earnings ratios of indices such as Sensex are already ruling at about 20. This suggests that the yield crash in the debt market has already been factored or partly factored into the stock prices.

Whatever be the case, a sharp rise in Sensex value from present levels to, say, 4,000 may not be supported by fundamentals. If it does rise, it can only come at the cost of future returns. Take, for example, the government security. If the price of that security rises from Rs 130 to Rs 140, for buyers at Rs 140 the return will only be close to 5 per cent and not 5.75 per cent. Similarly, if Sensex rises to 4,000 in the space of the next three months, returns from the level of 4,000 will be lower than 15 per cent per annum.

Retail selection: The implication for retail investors is that past levels of Sensex, such as 4,700, tend to be meaningless. A level of 3,800 may well represent a high from which future returns will be lower.

In this backdrop, buying now into large-cap or momentum stocks may only expose them to downside risks or fetch ordinary returns of 6-8 per cent over a longer term.

In this context, retail investors have to be more diligent about stock selection. A focus on strong fundamentals, a price to earnings ratio that is commensurate with earnings growth prospects, a good dividend record and, possibly, reasonable dividend yields will not do any harm at all.

In contrast, riding along with the market will only leave them with a sense of déjà vu — investors will experience a lot of thrill but without any returns to match it.

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