India's Good Times Are Over. Sensex May Not Return More Than 8 per cent per annum over 2011-2014......

Over the next three years, Sensex returns could disappoint, with a compound annual outcome of 8.3%. This is where the model has the best predictive power and essentially the message is that, for medium term investors, equity valuations are middling at the current level of short rates.

Key Debate: What does the combination of high short rates and middling equity valuations suggest about future market returns?

A modified earnings yield gap approach

We have modified the traditional earnings yield gap model, using short instead of long rates. The resulting earnings yield gap appears to have strong predictive power on medium-term (three-year forward) market returns. The R-squared of the relationship is 70%, implying that more than two-thirds of the three-year compounded annual return of the market is explained by this single variable.

What does this model say about the market?

We use this relationship to model the Sensex path over the coming three years. It suggests there is downside to the Sensex in the next three months (but has low accuracy for short term forecasts) but that, over the next 18 months, the market is heading for a substantially higher level, with the Sensex potentially breaking 30,000.

Safe Harbor Statement:
Some forward looking statements on projections, estimates, expectations & outlook are included to enable a better comprehension of the Company prospects. Actual results may, however, differ materially from those stated on account of factors such as changes in government regulations, tax regimes, economic developments within India and the countries within which the Company conducts its business, exchange rate and interest rate movements, impact of competing products and their pricing, product demand and supply constraints.

Nothing in this article is, or should be construed as, investment advice.