Will mean reversion work now?

Are Indian Equities likely to mean revert soon?

The most enduring investment case in equities is the tendency to mean revert. While average return rates are often touted as expected returns from assets, what most investors miss is the undulating nature of these returns. Equity returns are not linear. We have seen a considerable period of underperformance for Indian equities vis-à-vis their global counterparts in the past year.

Equity Index YTD Return (%)

Nikkei 225 (Japan) 21.99%

DAX (Germany) 21.74%

Shanghai Composite 19.01%

Nasdaq Composite 18.99%

S&P 500 (USA) 14.85%

FTSE 100 (UK) 14.76%

India Nifty50 5.62%

Given the above pattern what is the longer-term average, or the "mean" that these markets will tend to revert to? The 5-year averages for the same markets are as follows:

Equity Index 5-Year Ann. Return

Nasdaq-100 (USA) 13.8%

S&P 500 (USA) 10.2%

Nikkei 225 (Japan) 8.8%

DAX (Germany) 5.7%

FTSE 100 (UK) 5.7%

CAC 40 (France) 5.7%

MSCI China 4.0%

MSCI India 8.0%

Source: Nasdaq, Nasdaq, X (formerly Twitter), Curvo, Curvo, S&P Global, Curvo

Indian equities though shy of their all-time highs, are continuing to trade at above average multiples, especially in the mid and small cap area. Earnings this year so far have not justified the multiples these companies on average are trading at, which could lead to a sharp correction to longer term averages or a general de-rating across companies. The emerging situation vis-à-vis trade relations with the US could lead to significant reform initiatives, which may be positive from a longer-term perspective, but could cost the government in near term revenues leading to higher interest rates and inflation concerns.

Alternative asset classes are also flashing warning signs. Gold and Silver, a relatively uncorrelated asset class and a safe haven for anticipated volatility in capital markets, are themselves at life highs. So, if investors wish to reduce risk in their portfolios at this time by cutting financial market exposure may be in turn entering at historically high prices of these commodities. Not a good sign for reduction of anxiety. Real estate and other commodities also do not provide for satisfactory answers given where the industrial demand situation is likely to be. The impact of the possible reduction in hostilities between Russia and Ukraine is also unlikely to be discounted in the current crude oil prices. A supply glut could head oil prices downward.

How soon can the mean reversion happen?

As everything, stock markets take time to mean revert

• Global asset allocators do look to adjust portfolios based on long term average returns and “bank” some of the gains in relatively safer assets. India has been a market that global investors have been lightening their exposure to if latest SEBI data is anything to go by

• With emerging geo-political risks and the direction of the US Federal reserve and the move to induce lower rates, the USD could be at risk of depreciation. In a move to take non-dollar exposure, global allocators are looking at emerging markets and alternative assets, given anecdotal evidence

• India has not attracted country specific portfolio flows for a long time and there is not expectation that the trend will reverse. However, increased emerging market exposure in global allocations will naturally lead to increased allocation to Indian equities.

In addition to global capital flows, India GDP continues to remain poised for meaningful growth. Recent measures to reduce GST rates across a wide range of consumer related goods is a much-needed impetus to domestic growth. Earnings growth that had stalled in the past few quarters is expected to move out of the range and clock some solid gains. Given an abundant monsoon, rural demand is likely to be robust this year leading to continued optimism on the GDP growth front. Domestic liquidity continues to be robust and local retail investors in mutual fund remain optimistic of continued inflows.

Time to take a serious look at increasing exposure?

Given the above scenario, it looks a strong case for increasing India equity exposure. Just when the dazzling returns in Gold and Silver and Bitcoin carry the crown for the most recently concluded year, it just may be an opportune time to slowly but surely increase exposure to a relatively robust but poor performing asset class from a mean reversion perspective. The only caveat being the mean reversion can take longer than some expectations!