Rosy mkt forecasts are back; and why you should ignore them

Nazim Khanmoneycontrol.comAs the ongoing stock rally gathers pace, experts are increasingly becoming hopeful that this is a harbinger of a multi-year bull run that should create wealth for investors, and themselves.A classic sign of any bull market is the increasing number of lofty forecasts that are made in a bid to attract apathetic investors to the great run. But very often, such predictions fall flat in the face of reality as the years go by, leading to much disillusionment.In the history of forecasts, the most bizarre appeared in the US at the height of the dotcom bubble in 1999 when three books titled Dow 30,000, Dow 40,000 and Dow 100,000 were published in quick succession by three different authors -- with the numbers outlining the targets the Dow was expected to reach -- when the benchmark was trading at around 11,000 (and having already doubled in less than five years). Fifteen years on, the Dow is at around 17,000 levels.Even in India, when the Sensex reached 21,000 in a crescendo-like move between 2005 and early 2008, there were several forecasts that pegged the next target for the benchmark at 30,000. The Sensex treaded water for the next six years, taking out the 21,000 comfortably only recently.In the recent upmove, the Sensex has risen from about 18,500 levels to 27,000 currently in exactly a year (a near 50 percent move). Expectedly, analysts have upgraded both their earnings forecasts as well targets for the Sensex sharply over the past year or so.

Recently, Raamdeo Agrawal, joint managing director of Motilal Oswal, told CNBC-TV18 he expects the Nifty to reach 10,000 around the time of the Budget. Given that the Nifty and the Sensex benchmark values have historically had a ratio of about 3.3, this works out to a target for the latter at 33,000.That’s not all. Several brokerages and advisory firms have recently put out various long-term targets for the Sensex.HDFC Bank’s investment advisory division recently said it expects the Sensex to reach 40,000 by March 2017.In an interview with the Business Line, BNP Paribas managing director CJ George said he expects the Sensex to reach 60,000 by March 2018.While Karvy recently put out a much-discussed Sensex target of 1,00,000 by March 2020.Most of these forecasts are based upon a specific framework of assumptions of earnings growth and valuations.For instance, the earnings-per-share (EPS) for the Sensex stood at about Rs 1,300 in FY14. In March 2014, the Sensex was trading at about 22,500. This implied a trailing price-to-earnings multiple of about 17.2.While forecasting long-term targets for a benchmark, analysts assume its earnings would grow at a certain percentage and it would trade at a specific multiple.The earnings growth itself are often based upon certain assumptions for GDP growth (so, many analysts expect India’s nominal GDP growth to climb about 15 percent for several years ahead: 7-8 percent real growth plus 6-7 percent inflation) and assume that earnings of bluechip companies could top GDP growth by some percentage points. For instance, in the case of Karvy’s forecasts, it assumes earnings to grow at about 25 percent while forward earnings multiples (projected for the year ahead) would stay at 17 times.If the Sensex’s earnings was to grow 25 percent each year from FY14, it would stand at about Rs 6,200 in FY21. A forward multiple of 17 times would ensure the Sensex trades at a little above 1,00,000 in March 2020.But here’s the problem. Just as the stock market tends to not move up in a straight line, earnings of companies too do not.For instance, below is the chart for EPS growth for the Sensex since 1990. Over the long term, EPS has grown at an average 15 percent but this performance is marked by several years of superlative and underwhelming growth, alternatively.

As seen in the chart, earnings growth for the Sensex has been very volatile, often bearing little correlation with actual GDP growth, which tends to be more linear. In each of the six-year periods between FY90-FY96, FY96-02, FY02-08 and FY08-14, growth has averaged 28.7 percent, -0.96 percent, 23.4 percent and 7.7 percent, respectively.While 25 percent earnings growth is not unachievable and Indian companies have grown by that much in the past as can be seen above, that it may on average grow by exactly that much in the years ahead could be a risky bet.