Junk predictions, go long term

INVESTING

Sensex at 6,800 by January 31? Or 5,600? Rupee at 44.87 or 42.63? Euro at $1.21 or $1.4418?

I wish I knew. The unpalatable fact is that no one knows.

Twenty five years ago, Michael Mussa and Jacob Frenkel startled the financial economics community at the American Economic Association meeting with the key observation that asset prices are a "random walk".

Leaving apart the technical jargon of the trade, this empirical observation simply means that prices of financial assets are like specks of dust in a closed room, drifting randomly in all directions.

The key take away from Mussa and Frenkel's fundamental contribution is that asset prices cannot be predicted: it is impossible to tell whether the next tick will be up or down, forget time horizons of an hour or a day.

But there are caveats, and to understand these, we have to return to the speck of dust.

Recall the time when you observed the motion of small dust particles in a closed dark room, lit up by a beam of sunlight. The specks could broadly be drifting up or down, to the left or the right, but you could never catch one however hard you tried.

That essentially is the story of the markets: there is a broad trend which will manifest itself over a long period of time but you never know what will happen in the next few milliseconds. The usable term is "mean-reverting stationarity."

To put it very mildly, anyone who tells you the markets will rise or fall tomorrow is a quack.

And, journalists are a party to the quackery by parading these ill-conceived notions as "insights" into tomorrow's markets.

Nikhil Johri, chief operating officer at ABN Amro Mutual Fund says: "It is impossible, impractical and inadvisable to go by next day stock market predictions and investors are advised to take a medium to long term investment horizon in equity."

As Gurunath Mudlapur, head of research at Khandwala Securities puts it, "there is always a 50:50 chance of being right. Everyone sees the markets from his own vantage point. One guy's view of the market is but one of the million views at any point in time, but each one would like to believe that he is right, and his views reflect the dominant view."

In concrete terms, everyone in the market agrees that with a 6.5 per cent plus economic growth, disposable household incomes will grow. There will be demand for goods and services. Companies will sell more and mint more money.

Valuations will improve. So, over the long term, the broad trend in the equity markets is upwards and the dollar will weaken further on deficit concerns.

But what of tomorrow? Dunno, because no one will ever know the dominant force in the market by this evening, whether unsatiated greed will drive valuations higher or abject fear will make people take money off the table.

N Sethuram, chief investment officer at SBI Mutual Fund, said: "No stock market 'pundit' can predict what will happen in the equity market the next day. It is impossible to predict very near term trends and get them right all the time. In equity, eventually it is the long term-players who make the money with most day-traders lose money some time or another."

Now, this is not supposed to be a tutorial on behavioural finance. But then it will still be useful to remember that when the going is good, like three weeks ago, each one in the markets had dismissed all possible negative factors. Today, why is that even a sharp 120 point rally is being dismissed as a "relief rally?"

To fathom these primal urges, it will also be useful to spend sometime on investor behaviour.

As Khandawala's Mudlapur argues, everyone in the market looks askance for a "reason" for the day's rise or fall in the indices or in stock prices.

No one knows for sure, but like the five blind men describing an elephant, each one professes a view based on his or her experiences in the day.

If there were 20 sellers, it stands to reason that there some buyers for the total quantity sold.

Ask the sellers' side, and they will quote stretched valuations as the considered reason, if not plain vanilla "profit booking at these levels."

Ask the buyers' side and it will say the stocks were looking attractive at battered down prices. The views then get etched in the investor's mind as "the" reason, and his follow-up action tends to go in the same direction.

Deven Choksey, chairman and managing director, K R Choksey Securities, said, "Short-term call are possible, but they don't make sense as markets run on many dynamics. So, one day of buying may spill over to another day of even more aggressive buying and on the flip side, one day's of genuine profit booking may spin uncontrollably over the next few days of panic selling.

One day's "reasons" will get reinforced over the next days. At one point, investors will see no wrong and at another point, they will see no redeeming factor though the elephant remains the same.

The economics profession calls it a sustained deviation from the fundamentals. It happens in all asset markets, but in the long term, prices revert to the mean (the average) price determined by fundamentals.

What does this mean for equity market investors? One simple but bitter point: don't look for quick money.

As SBI Mutual's Sethuram says, it takes time for valuations to unwind and the fundamentals to play out, and hence it is prudent to have a long-term investment horizon.

Choksey puts it in more practical terms: "Instead of a target for the index or the stock price, it is prudent to have a target on the kind of return one is expecting and act accordingly."