March 2018: Long-term Market Returns move in line with nominal GDP Growth

The Nifty closed the financial year, FY2018, with a 10.25% gain – in many senses this has become the average return of the Nifty in recent times. The Nifty has compounded at 6% pa on a 3 year basis and about 12% pa on a 5 year basis. It is worth remembering while comparing returns over any period, to try and keep in context the valuations at the beginning and end points and the environment that they represent. The 3 year return is low because it is on the base of the strong rally in the Nifty in the year ended 31-Mar-15, when the Nifty was up 27%.

When one looks out at longer time frames, the 10 year return on the Nifty is 7.9% pa while the 20 year return stands at 11.6% pa. It is important to note that once you are analysing 20 year and longer duration returns, the starting and end point valuations are less relevant in determining the final result. Some under valuation or overvaluation at either the start point or end point gets neutralised by the long period over which the return is being calculated.

It is interesting to compare the returns generated by the Nifty over the years to the growth in nominal GDP over the same period. To give a context, the typical GDP growth number which one normally reads about is the ‘real GDP’ growth, which closely represents the volume growth in GDP. Real GDP has been averaging 7.0-7.5% pa growth over the past several years. Nominal GDP, on the other hand represents the Rupee growth in GDP – which includes the ‘real GDP’ and the increase in selling prices of products, or inflation. Nominal GDP for the year ended 31-Mar-18 (estimates) has grown at 10.1% pa over a 3 year period and 10.7% pa over a 5 year period. Over the 10 and 20 year periods the nominal GDP growth is 12.8% pa and 12.5% pa respectively. The lower inflation in recent years may be one of the reasons for recent numbers to be lower than long term averages.

We have seen that the return from Nifty has been close to the rate of growth of nominal GDP over long periods of time. Revenue growth of a collection of large companies tends to converge with nominal GDP growth, which in turn reflects the intrinsic value growth of these companies, and therefore the long term expected stock market return. Note that we are using nominal GDP – i.e. GDP not adjusted for inflation because we are comparing it to Nifty values which are also not adjusted for inflation.

The above analysis of long term Nifty returns, particularly the 20 year growth numbers, should give us some sort of anchor as to what to expect in terms of market returns over long periods of time. From that perspective, the year that went by, was close to an average year. There has been some conversation lately that the market is over-heated. While this is partly true with respect to mid-caps and small caps, when one looks at the Nifty returns over 3 years (6%), 5 years (12%) and 10 years (8%), we see the numbers are fairly close to their long term averages. This implies that the returns of the large caps which represent the Nifty, have been in line with historical norms and do not exhibit a great amount of exuberance, as is being feared by some investors. It is important to have realistic expectations of what returns the equity market can deliver and this can help avoid making mistakes while investing.