For the past five years, the Indian stock market has given no returns. Stock markets in many countries are negative over a decade or more. What to make of this? Turning your back on stocks would be a mistake. Debashis Basu with Jason Monteiro explains how you should really invest

Debashis Basu & Jason Monteiro

Nothing seems to be going right for believers in equities for years now, whether in India or in major economies around the world. Last year, the Sensex fell by 25% in a heap of gloom and doom. The stock market rose by 20% in January 2012 but, by the end of May, almost the entire gains were wiped out. Since then, it has done better. After about three quarters of the calendar year, the stock market is up by about 15%. But nobody is really confident that the gains would last or that the stock market is headed steadily higher. Stocks are supposed to do well for the long term but that belief has been shaken. The reason is obvious. The Sensex is now at around 18,000. Two years ago, it was at the same level. In October 2007? The same level. One of the human traits is to focus on recent events. And recent events have not been kind to believers in the equity cult.

Can’t blame them. Five years are over and the Sensex stocks have delivered no returns (excluding dividends which really yield less than 2%). Money in the bank would have compounded at 9% a year and your wealth would have been up 50%. This fact is hard to ignore. But those who have an understanding of stcok market history would not be surprised.

In June last year, when we discussed the markets (see Cover Story “Bull Doze”, Moneylife, 2 June 2011) we had said that “large gains from the market are probably a thing of the past. We are in for a period of average gains for an extended period.” We had also suggested that “for most other periods, the markets trend in a broad range, in line with growth and valuation. If they are near the top of the range, they go down on negative events. If they are near the bottom of the range, they rally on positive events. By all accounts, we are somewhere near the middle of the range—and amidst a scenario of slowly deteriorating fundamentals and macro environment.” This observation has turned out to be right.

However, what we are witnessing around the world is not just poor performance of stcok markets over a few years. It’s much deeper than that. Equity indices have disappointed for years now. At least, the Sensex is way above the bull market peak of 6,150 in the year 2000—up 300%. The broad US gauge, S&P500, is still well below that (See chart). The Chinese stock market looks decimated. Japan’s Nikkei is the poster boy for why you should never invest in equities. The issue for stock markets is no longer a few years of market underperformance. It is underperformance across many years, possibly decades, across many countries. It is about equities being bad for wealth.

It is about the death of the equity cult. In the most stunning reversal for the equity cult, over the past 30 years—between 1981 and 2011—bonds have outperformed stocks, something that should never have happened if equity truly does better than bonds over the long run. Indeed, stocks had risen more than bonds over every 30-year period from 1861, according to Jeremy Siegel, a finance professor at the University of Pennsylvania’s Wharton School in Philadelphia.


The future does not look bright either. The gloom and doom of unemployment, European debt crisis and miserably slow growth is enough to keep people away from stocks. In the home of equity cult, the US, disappointed investors are dumping stocks. Equity mutual funds of the US have seen an exodus of 395,196 million dollars from 2008 to 2011 according to data from Investment Company Institute 2012 Fact Book.

To make matters worse, a smart guy like Bill Gross has attacked the core belief of the equity cult itself—the assumption that historical returns from equity would hold in future as well (see Box). Gross, one of the best bond investors in the world (he co-founded the largest bond fund Pimco), argues that returns from equities will be much lower at around 3.5% per annum over the long term.
What should we make of all these overwhelmingly bearish data and opinions? This article will explain what it really means. Before we get into the details, remember investors’ opinions about what the stock market will do in future is based on what they read in the media (Internet, TV and print). It is not based on their own original research. Unfortunately, a lot of what you read in the media is egregious (which makes for good copy) and ill-researched. This is because journalists suffer from the same flaws in thinking as investors do (such as bias towards recent events, hindsight bias, impressed by large numbers, etc). All this compounds investors’ mistakes. One of the best examples of how media can be hopelessly wrong about stcok markets is the Cover Story of Business Week magazine in 1979 which, surprise, surprise, predicted the “The Death of Equities”. At the time the story was written, the stock market had sustained serious losses and the long-term health of the US economy was a significant concern, after the debilitating Vietnam War and two oil price spikes. But that article called the bear market bottom. A few months later, the US market stabilised and then launched into an 18-year monster bull market that ended in 2000. Investors, who ignored the negative narrative of ‘death of equities’, struck gold; those, who ‘paid attention’, missed the greatest bull market since the 1930s.
 

A sideways market is normal

As we have said, it is perfectly normal to have a situation when the stock market does not go anywhere for years together. Look at what the Sensex did in the September 1994 to December 1998 period. It was down 28.63%, frustrating the believers of the equity cult. Nothing seemed to be going right for the Indian economy and corporate sector. High inflation, high interest rates, and messy political alliances kept investment and consumption down for years.

Take a look at the Dow Jones Industrial Average over the past 100 years. There have been at least three periods, including the current one, when the stock market has been stagnant for over a decade. The first was the post-Depression period that lasted from 1929 to 1946. This was followed by two decades of stcok market rise. The second was in the 1966-82 when the Vietnam War and the oil shocks racked the economy. But this was followed by a period of falling interest rates, globalisation, rising productivity and technological leaps, leading to an 18-year bull market between 1982 and 2000. For the past 11 years, the market movement has been sideways. There is nothing abnormal that the Indian market has been flat for five years.


Timing Matters: It cannot be anybody’s argument that no matter when you buy stocks, they should go up over the next five years. Unfortunately, most analysis is done on the basis of point-to-point returns, to display stock market returns. As everyone knows, with the benefit of hindsight, if you invest when valuations are expensive, you will be disappointed by subsequent returns. On the other hand, the best investors in the world have not only bought good stocks for the long run but at a time when such stocks are sharply down and everybody is deeply fearful. A French proverb, attributed to one of the Rothschilds, goes: “Buy at the sound of the canons and sell at the sound of clarions.” Warren Buffett has been quoted as saying: “Be fearful when others are greedy and be greedy when others are fearful.” This is the cornerstone of successful investing—not just buying any time and holding for the long run.  


A stock market is a market of stocks: The more important question is: what does a flat market index have to do with investing success? What have your returns got to do with the Sensex movement? An index represents just a few stocks with more weightage given to stocks with a higher market-cap. Investing in equities should be done based on value and not the price of the stock. Hence, a stock with the highest market-cap may not necessarily mean that it is fairly valued. In reality, a smart investor would not invest in a stock that is expensive but in one that is undervalued. This stock may not necessarily be on the index, but it may provide returns far better than the index. In the mid-1990s, when the index went nowhere, if one had been investing in top growth stocks of that time, such as Infosys or Hindustan Unilever, returns would have been excellent. While the Sensex was down between September 1994 and December 1998, stocks like Hindustan Lever soared by 152%. And a growth stock like Infosys rose by as much as 1027%. Over the past five years, when the stock market has been stagnant, look at the performance of individual stocks like ITC, HDFC Bank, Sun Pharma, V Guard and Kajaria Ceramics. These stocks have created enormous wealth for the investor, despite being part of the same sideways stock market.


If you cannot trust yourself to buy when others are fearful, or buy value stocks and avoid expensive ones, there are other ways to invest successfully—like systematic investment in good quality mutual funds so that you can average your purchasing cost. An increasing investment in one of the top mutual funds would have beaten the market handsomely over the past five years.

To sum up, the gloom and doom about the Indian economy that is continuously propagated by the media is justified. The economy is dragged down by policy paralysis and corruption, factors that are affecting the performance of top Indian companies (some of which happen to be in the Sensex). But this should have little to do with your investing strategies. Talk of the death of equity cult and long-term returns are academic because your returns are not linked to the Sensex movement. Tune out all the media noise about gloom and doom and stay focused on discovering value in individual stocks and mutual funds. We have a large section on stocks in Moneylife that reflects precisely this approach. The Value Picks section is a basic shortlist of stocks that combine high return on net worth and low valuation. Our choice of stocks in the Street Beat section also reflects this approach. Most people lose money in stocks due to poor methodology, large positions taken at wrong times, inability to take a loss and blindly trusting others. Additionally, there are emotional factors at play like panic, greed, regret and confidence. Many go by ‘expert’ advice from the media and random tips.

If stock-picking is not for you, then you can seek professional management through mutual funds. We have also periodically brought to you the best funds to invest in. Not all mutual funds beat their benchmarks, but there are a few that have a long-term track record and have beaten their benchmark substantially. In fact, when we did an SIP in one of the better performing mutual funds, we found the number of periods of losses reduced significantly compared to those for the Sensex.


Death of Equities

Core Belief Questioned

Professor Jeremy Siegel’s bestseller Stocks for the Long Run looked at the data of returns from bonds and stocks between 1871 and 2006 and concluded that stocks have outperformed bonds in a majority of the periods. The longer the holding period, the better are the chances of equities outperforming bonds and other fixed-income assets. Even from major market peaks, the wealth accumulated from stocks is more than four times that from bonds where the holding period has been 30 years. His research found that over periods of 20 or more years, stocks are not only the best investment for your money, but the safest as well, returning 6.5%–7% after inflation while bonds and other investment vehicles fared considerably worse. This return (around 6.6%) from stocks is now popularly called ‘Siegel’s constant’.


Bill Gross, a top bond investor and co-founder of US investment firm Pimco, disagrees. He argues that future returns can’t possibly be as good as they used to be. Gross points out that the inflation-adjusted return from equity at 6.6% over 1912-2012 (Siegel’s constant), is a ‘historical freak’. He asks: if the real GDP itself grows at an annual rate of 3.5%, how can stockholders skim off 3% every year on top of it? “If an economy’s GDP could only provide 3.5% more goods and services per year, then how could one segment (stockholders) so consistently profit at the expense of the others (lenders, laborers and government)?” Gross points out how this was possible in the past and will not be possible in future. According to him, the real wage gains for labour have been declining as a percentage of GDP since the early 1970s, “a 40-year stretch which has yielded the majority of the past century’s real return advantage to stocks. Labor gaveth, capital tooketh away in part due to the significant shift to globalization and the utilization of cheaper emerging market labor. In addition, government has conceded a piece of their GDP share via lower taxes over the same time period. Corporate tax rates are now at 30-year lows as a percentage of GDP and it is therefore not too surprising that those 6.6% historical real returns were 3% higher than actual wealth creation for such a long period.” According to him, what “analysts, government forecasters and pension consultants should answer is how that 6.6% real return can possibly be duplicated in the future given today’s initial conditions which historically have never been more favorable for corporate profits.”

He asks, “If labor and indeed government must demand some recompense for the four decade’s long downward tilting teeter-totter of wealth creation, and if GDP growth itself is slowing significantly due to deleveraging in a New Normal economy, then how can stocks appreciate at 6.6% real? They cannot, absent a productivity miracle that resembles Apple’s wizardry.” His answer: the Siegel constant of 6.6% of real appreciation, therefore, is “a mutation likely never to be seen again as far as we mortals are concerned.”