Unhedged Position: Can India See An Indonesia-Style Time Correction?

News broke over the weekend that MSCI was considering removing the Indonesian market from its emerging market index, pummeling the country's stock index to a more-than-a-decade low.

A stock index giving zero returns for more than a decade sounds like an aberration when it is commonly believed that equities generally go up in the long term.

In fact, a 2021 study that tried to look for evidence of this exact claim found evidence to the contrary. It found that in the context of US equities, there is a 12 percent chance that stocks will fail to beat inflation even over a 30-year period.

And increasingly, there are examples that stock indices are failing to yield positive returns, even in nominal terms, over long periods of time.

For instance, the Japanese Nikkei was able to overcome its 1989 level only last year. The Chinese Shanghai Composite is currently trading below its 2007 level. There are other examples too: Hong Kong, Italy, Spain etc. have all delivered zero or negative returns over the past two decades.

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Before you dismiss Japan or European markets as a basket case, or China as a market that is not taken seriously by investors because of its tightly-regulated structure, it must be remembered that the Indian market, too, delivered zero returns between 1992 and 2003. Even the US stock market has delivered zero returns over 27 years (1929-1956), 24 years (1968-1992) and 14 years (2000-2014).

Now, there are two problems in (cherry?) picking specific dates to underline a long-term price correction. One, typically, the start date is one that comes soon after the market has performed very well, and a moderation is in order. For instance, the Sensex grew fivefold between 1988 and 1992. And two, it ignores what happens in between: i.e. the index doubled between 1998 and early 2000.

But the above exceptions are what justify the rule: that investors must still be wary of believing that oft-communicated message that stocks always go up in the long-term.

After all, it is at the peak of a bull market that most people heavily buy stocks. And very often, once investors see a loss on their portfolio - either through a spectacular price crash or through a painful time correction - they typically hold on to try and recover their losses because they have anchored the purchase prices in their heads.

The performance of the Indian market therefore becomes important in the context of the key argument made above. 

The Nifty is trading below levels it first clocked in 2024. Is there, then, as I have suggested in the headline, potential that the current time correction drags on painfully for the next three-five, even ten years?

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That cannot be answered before spelling out the nuance beforehand.

After all, the market could go up 50 percent over the next few years - and all becomes well with the world for investors -- before falling 33 percent to come back to the same level. (Blame the brutality of math: an asset must fall only 50% to erase a 100% rally, or 80% to wipe out a 400% surge.)

Or the market, as it has done in the past, frustrates and throws off weak hands, before rising in a thinly-participated rally that few benefit from.

If one must still hazard a guess, the PE ratio typically is the best metric to use. The farther the index's PE ratio sits above the median, the higher the chances of long-term under performance.

The index now sits just around the median. So, if earnings continue to grow at a decent clip over the next many years, which they should, the market will grow about as much in percentage terms over the long term, even if the PE ratio doesn't go up, as long as it doesn't go down further.

There are tail risks that could cause the PE ratio to compress: hyper-inflation triggered by monetary policy excesses of western central banks, deflation triggered by advances in artificial intelligence, or large-scale wars triggered by the changing global order.

The tail risks are the ones investors must account for when building out their margin of safety calculations.