What will drive the Sensex in 2015?

Mean reversion, political cycle and US interest rates to impact equities far more than GDP growth

Towards the end of 2014, equity strategists came up with bullish reports on the potential returns that Indian equities would generate. Some made a case for higher returns by forecasting higher earnings growth, while others justified their stance on India by assuming higher economic growth. But is this enough to drive the Sensex to new highs? Some believe it's neither economic growth nor higher earnings trajectory that have a clear correlation with market returns.

Ambit Capital's done the math and the brokerage says there is no meaningful relationship between Sensex returns and EPS growth between FY-1992 and FY-2014. Instead, what drives the Sensex is mean reversion, which essentially is a theory that eventually returns and prices move back to a historical average. Says Saurabh Mukherjea of Ambit in a note, "Over the last 30 years, there has been a pronounced tendency for the Sensex’s returns to revert to the mean, with the mean being around 17%, marginally higher than the cost of equity in India (which is likely to be around 15%)."

After the sharp 34% the Sensex returned in 2014, chances of it returning returns in mid-teens are high. Kotak Institutional Equities expects about 15-20% returns from Indian markets in 2015 and valuations are reasonable with the BSE 30 trading at 15 times FY16 earnings (free float).

And like it or not, the political cycle seems to have a bigger bearing on Indian equities than earnings or economic growth. The year 2009 is a classic case in point, when the world was in the grips of a massive financial crisis and India also suffered from the reverberations of that crisis, when growth declined and markets tanked. But soon after the 2009 elections, markets rose. The Indian economy moves in cycles that last 8-10 years. At the start of any economic cycle the returns are most handsome, as has been witnessed in 1991 and 2004. The first three years have delivered better returns compared to the long-term average of 16%.

Finally, the big mover and shaker of Indian equities is the US interest rate cycle. But rising bond yields is not bad for India. Every time bond yields in the US have tightened, Indian equities have fared well as money tends to flow out of US bonds and into global equities. So 2015, could be another stable year for Indian equities.