The so-called "law of averages" is often invoked in ridiculous circumstances. For instance, say a gambler has called tails five times running on the toss of a fairly weighted coin. He has lost each time. Should he call tails again?
Yes, according to the (non-existent) law of averages. After coming up heads five times, the "law" says the coin "should" come up tails. Actually, the coin has no memory. The odds of coming up heads or tails remain 50:50, regardless of prior toss history.
At first glance, this is similar to a situation where a gambler bets on the price of an asset going up or down. But while price movements are almost random, they are not quite so. Prices do have some memory, because traders remember the points where they have made or lost money.
The "memory" leads to clustering with price points associated with heavy volume. Some traders remember that they have bought at price X and made profits so they are prepared to buy again at X. At another price Y, another bunch of traders recalls painful losses so they are likely to sell if Y is reached. There will be clustering and high volume at X and Y.
This collective memory also implies a tendency to mean-reversion. A stock which has shot up is likely to come down; a stock which has fallen steeply is liable to recover. In that sense, a law of averages does often work in the stock market.
More than prices, valuation ratios see mean-reversion. A given stock, or an entire market index, will tend to trade within a price-earnings (PE) band. The earnings will change over time and prices will change accordingly. But the PE band, with its maximum and minimum values, will hold over long periods.
There can be extraordinary periods when the mean reversion goes haywire. In a bubble, valuations go through the roof due to excessive optimism and liquidity. Deep in a recession, valuations might also be depressed to below the floor of the normal band.
The past two years have been strange. India has been in a recession and one would have expected prices to be trending towards the bottom of the PE band. However, there has also been a flood of global liquidity and that has buoyed prices up.
Despite the liquidity, valuations through calendar 2013 averaged out at 17.8 PE for the Nifty, which is lower than the 10-year average. The 10-year average PE of the Nifty is 18.7 with a standard deviation of 3.2. About 69 per cent of all valuations fall within one standard deviation of the mean (15.5-21.9 PE) and 97 per cent of valuations fall within two standard deviations (12.3-25.2 PE). So, this conforms to the normal statistical distribution.
The flood of liquidity is easing down with the taper. Earnings growth has not, however, recovered to any great extent. Does this mean valuations will now revert lower? It seems likely. That's the case for being cautious. The case for being bullish, of course, is that PE is below the long-term average.
One could be both cautious in the short term and optimistic in the long term. I'd expect a correction in 2014. Valuations could drop somewhere between 13 and 15.5 PE as the taper increases. That is, the Nifty might correct to somewhere between one and two standard deviations down from the long-term average. Earnings will grow at 10-12 per cent. Adjusting for both, a price correction of between five and 20 per cent seems reasonable. Markets have a tendency to overshoot, so, corrections could be deeper.
The fear of a correction should keep the investor from going overboard. But valuations being below the long-term average should keep investors committed. The best way to handle such a scenario would be a systematic investment plan (SIP), where the investor increases commitment on corrections. If there is no major correction, the SIP is maintained at a steady level. This way, the investor should gain in the long run, whatever happens.
