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Where is the stock market heading? - Part 3 - Investor Bias

It makes so much sense to begin this article with a famous quote said by Sir John Templeton in 1993.

"The four most dangerous words in investing are: 'this time it's different.'"

This time it’s different. “It’s”. What is the context of this word? Ask any person and you would probably get different answers. Markets are different, Times are different, Economy is different, Technologies are different, Events are different. But there is one which isn’t different. Let me leave it there and come back to it a bit later.

In part-1 applied the Dow Theory to understand about the current market structure, while part-2 applied Fibonacci Retracements to understand the supports and resistances in the coming weeks and months. This part will not cover theories or technical analysis, rather, will cover the market factors that affect stock prices in real-time.

Sustained Recovery?

Ever since NIFTY made a panic low of 7511 on March 24, 2020, the index has made a smart recovery, climbing the wall of worries. The index has formed higher lows and higher highs. FII has been buying. Lock-down has been lifted, Industries have been opened, pollution has been increasing and investors back to their usual business. Elsewhere on the global front, NASDAQ has hit lifetime highs, SPX, DJIA, DAX, FTSE, Nikkei recovered more than 80% of the fall breaking all technical resistance. Fed is on a liquidity drive and is expected to provide additional liquidity boost whenever there is a hick-up by the stock market, thereby safe-guarding investor interests. Even though the Indian indices are currently under performing the global indices, it is expected to catch-up sooner than later, as soon as India is able to flatten the COVID curve. The stock market discounts everything and it seems that the worst is behind us as the COVID induced crash is digested by the market and looking forward to the next Bull Run. Stock calls are back on the street by brokerage research firms and the hunt for the next multi-bagger is on.

Reality Shift

Ask any investor at random and that is what you will likely to hear. It feels like gospel. The whole of the last paragraph is constructed out of one emotion, Hope. Likewise, the rally has seemingly climbed the wall of worries in hope that the disruption due to COVID is minimal and there will be no more surprises. If you look back at it, currently we have no data yet, that provides proof that the disruption is minimal. Of course, the US unemployment ratio improved “marginally”, but when compared with a historical low, the comparison would always give a positive outlook. This is called base effect.

For example, Maruti’s sales data was 0, during the month of April. But it “increased” to nearly 14000 units in May. This was still much lesser than the 72000 units they sold in March. Moreover, the sales numbers of May could have included the Cars that were supposed to have been delivered in April. Buyers would have booked the cars in advance prior to the lock-down, which means, mostly delivery commitment was achieved during May. We do not know how many cars got booked in the month of May. This is why emphasis should not be laid on standalone data. A better supportive argument in favour of market reversal should include consistent back to back data. Until that is received, a view is not backed by fact. But that doesn’t mean, the sales data would not improve from here on. It definitely could, but until the data is available, you have to give the benefit of the doubt to the preceding market conditions, to avoid tripping over due to the base effect.

But, the global markets have almost pared all losses and have recovered, which can only mean the beginning of a new bull market, right? Maybe it is right to assume that way. At the same time, the underlying factors contributing to the melt-up should be put into perspective too. This article by The Guardian explores why the global markets are rising. In brief, central banks across the globe have been on a liquidity injection spree also known as quantitative easing. As long as the liquidity is used to revive demand, it makes sense to the real market in the long run. But, if the liquidity is used to bulk up the asset prices, it means trouble and unfortunately that is what is happening. The liquidity is absorbed by companies and a sense of invincibility creeps into the investors that the central banks will keep pumping money every time the market takes a hit. This leads to blurring of risk assessment on the investor’s part, thereby inflating an asset bubble. In addition, the debts of companies are mitigated by providing access to additional debts, which causes a debt bubble as well. A twin bubble adds more reason to be cautious. The stock market rally could be a short-term melt-up, that should not be interpreted as improving fundamentals, until the fundamentals themselves say so.

Supply-Demand Conundrum

When COVID originated in China, it was initially seen as a Supply shock. Most economies were either directly or indirectly dependent on China for industrial supplies. India was in a prime position to benefit out of this situation to grab some market share from China in manufacturing sectors. But when the virus spread across the world, the supply shock became a demand shock. Demand from across the globe faced severe contraction and whatever advantage which India had was nullified to some extent. India’s export to GDP ratio is 19%. With COVID restrictions getting lifted, the global demand would improve to bring back normalcy to trade. This is the general outlook of the market. But investors are not discounting a hidden outcome of COVID, De-Globalisation.

Globalisation was the theme of the global economy over the past few decades, but most of the countries are now promoting de-globalisation and the supply disruption caused by COVID has reinforced this agenda. Make in India, America First initiatives are populist themes that might help satisfy the internal demand. But, it also means the foreign countries are going to impose the same restrictions on their imports as well, meaning cross country trade will taper, leading to an imbalance in the demand. China faced significant contraction on both imports and exports for May and it could be no different for India as well. Products and commodities that are more favourable to the local population will see demand spurt, meanwhile export oriented sectors will see a demand slump. This unhealthy balance of sectors could cause significant problems to the domestic sectors themselves eventually. Due to the export oriented sectors losing sheen, entrepreneurs will be forced to move to the domestic sectors thereby causing overcrowding. That reduces the profit margin due to competition. When there is high competition in a sector, the PE ratio will be low, meaning lower valuation, affecting stock prices. But in-spite of the risk of de-globalisation, it is not expected to be in totality and there would definitely be a middle ground. Which sectors would benefit and which sectors would not, will not get revealed so soon and our depends if policy changes that are expected to come.

De-globalisation will lead to new growth opportunities within the country and gives a reason to build capacities in certain sectors. But there is a caveat, domestic demand should be supportive to match the supply, for companies to ramp up. India’s trade(Import & Export) to GDP ratio is 43.38%. Whatever contraction that happens to this ratio through de-globalisation should be supported by domestic demand. Currently, the domestic demand is poor not just due to COVID, but the demand was reducing even before COVID evident from the GDP & PMI forecasts since last 1 year.

COVID brought the domestic demand to a virtual stop due to the lock-down. The disparity between the wealthy investor class and the poorer labour class is evident as the liquidity driven stock prices sees a bounce while people have to contend with realistic worries about job and income. It is a human tendency to become protective of finances during difficult times and the demand is expected to be under pressure for some more time. With the lock-down lifted, industries are opening up their production facilities though with reduced capacity. Especially since the demand is low, there is no incentive for companies to ramp up production when there are stockpiles in warehouses and shops/showrooms yet to be sold. Again taking Maruti's example, the month of may saw 98% cut in production. Only demand can revive production at full capacity. Without 100% capacity utilisation, companies will not do CapEx or increase employability. That in turn leads to less employment and less salary in the consumers' hands to pick-up demand. It's a vicious cycle that can only be broken by external push from the Government. Until its broken, demand will continue to dissipate. Companies will not do that themselves. Providing loans to consumers would not help because with the fear of unemployment would either prevent them from taking the loan or they would take the loan to satisfy other off the market monetary commitments, that does not directly boost demand. Likewise, loans to companies are more likely to be spent on managing operational losses, instead of safeguarding employee interests.

This conundrum makes it clear that Supply drives the Bull Market, but only Demand can drive the market during Bear Phases. Unless demand is created, there is no incentive for the industries to expand.

Investor Bias

That leads us to the important question. Have the investors and the market at large really discounted all these to form a bullish view? With so many open questions and uncertainty around the economy, the situation is too fluid to find a strong footing for the market. Yet the market rallied too fiercely and too quickly, which makes us wonder how could the market have discounted all of this with inadequate data and clarity?

A possible explanation to this question could be given in-terms of Investor Bias. A decade long Bull Run could have dulled the investor’s senses to perceive risk. For the past few years, the theme of investment has been “Buy On Dips”. Based on psychology, anything that is practiced for 3 months, becomes a habit. Likewise, the buy on dip strategy has subconsciously become a habit for investors over the past few years, leading to unconditional bullishness. Hence even a deep fall in stock prices is viewed as an opportunity to accumulate instead of thinking before acting.

It is generally said that a bear market ends when the last bull is converted into a bear. But currently that doesn’t seem to have happened yet. The latest Mutual Funds data published by AMFI show that the SIPs are still coming in strong, though there was a slight dip in inflows. This was in spite of the 39% fall seen on Nifty in March. Obviously the sharp drop in the fund returns would have triggered significant concerns for the MF investors, but the equally quick recovery would have soothed some nerves and reinforced the Buy on Dip mindset. By no means, it is wrong to be invested through goal based systematic investments. But, the subconscious bullishness should not override the ability to perceive risk, leading to FOMO induced over-investing by pumping in more money than planned, since the market has corrected 39%. Systematic investments should continue, but the exposure to risky assets should be revisited if the person’s financial health is not inline with the asset allocation under current circumstances.

Another reason for the investor bias could be due to positional bias. When a stock is brought into the portfolio due to strong fundamental reasons, a target is set subconsciously. So even when the underlying fundamentals of the stock or the situation surrounding the stock changes, the human mind narrows the reason for holding the stock towards the monetary target that was already set, instead of focusing on the fundamentals that has driven the investment in the first place. This is called positional bias. Positional bias sometimes becomes more powerful that the stock’s monetary target gets projected to the stock market itself in entirety. This eventually causes the view that we have on the stock to dominate our perception of market risks at a macro level. The investor rediscovers the ability to perceive risk only when the stock the investor is married to, is removed from the portfolio. Suddenly, all the risks that were thus far blurred out, comes into view again.

Now, going back to Sir John Templeton’s quote, "The four most dangerous words in investing are: 'this time it's different.'"

Hopefully, now you could get the context of why it is dangerous to assume that, this time it’s different, even though practically everything has changed on how stock markets work over the past few decades. What isn’t different is human psychology. Human’s behaviour towards bear phases after sustained bull phases is always the same. As humans, we carry the gene over millennia to behave in a certain way while encountering similar situations. Our mind is wired to work that way. That is why we see a market pattern over and over again, in spite of different triggers and outcomes. Be it the great depression, the DotCom bubble, the Subprime crisis etc, the human mind reacts the same way by overlooking or interpreting economic data too quickly. The Dow Theory represents just that, a projection of the human mind onto the stock market behaviour.

Greed is still prevalent across the market. If a 39% dip could not suppress greed, it is frightening to imagine what it would take to convert the bulls into bears. By the time the stock market bottomed out in 2008, the most prevailing feeling of investors and traders were that of despair and hopelessness. That's how the bear market ended, but we are nowhere near such a sentiment right now. This could mean only 2 things. Either, the bull market never ended in the first place and this is just a freak crash, or we still have a long way to go. Until some clarity emerges, maybe ignorance is bliss, to gel with the market sentiment.

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