When you look at the market, usually you look at the sensex to gauge the market's direction. Although investors and market watchers often confuse it, for the sensex, numbers like 15,000, 17,000, 20,000 are not mere numbers. For the index, these numbers represent a strong relationship to the earnings of the 30 companies that constitute the market's benchmark.

Here, we will try to understand this relationship which may lead to more clarity when we deal with the market in general, and sensex in particular.

Some of us think that when the sensex was at 3,000 levels about 10 years ago, it was cheaper than the 18,000 levels that it is now. This is not true. Since the index is a multiple of combined earnings per share (EPS) of its 30 constituent companies, if the index is at 18,000 and if the combined EPS is at 1,200, then the index multiple is 15 (1,200x15=18,000). This is also called the PE, or the price-to-earnings ratio.

To have a simple example, we assumed a constant PE of 17 for say six randomly selected representative years over a 14-year period, and took the actual EPS for these six years. Then we multiplied these EPS numbers by 17 and arrived at sensex levels for those years, as given in the first table.

During the 11-year period from 2002 to 2012, earnings grew at an annualized rate of 16%. The sensex level of 3,774 in 2002 and 19,261 in 2012 is one and the same. How? In 2002, at an EPS of 222, the index had a multiple of 17 which gave the number 3,774.
Likewise, in 2012, with earnings of 1,133, the index level of 19,261 was 17 times the EPS. If this is understood, we can see sensex with a new perspective and not as a mere number.

Now the earnings growth here is our investment return. If the earnings grow at 16%, our investment return over the long run would be the same, and there are empirical evidences for developed markets which validate this.

So what happens in the short term?

The market return (as measured by sensex levels) would be more or less than the investment return.

If the investment return is 16% and the market return is 25%, this implies a speculative return of 9%.

If the investment return is 16% and market return is -15%, this implies a speculative return of -31%. The speculative return varies from year to year. But over the long run, the speculative return tends to be zero.

So what matters for us:

The earnings growth or investment return? Periods of negative speculative return would be followed by periods of positive speculative return and vice versa.

So we need to ignore both and look at only the investment return which is the true measure of one's return.

In another way, since price and value always converge in the long run, we should focus on the value, and price would take care of itself.