Markets are Always Right?

30 OCTOBER 2020

After the 60% surge in Indian stock market indices since their post-COVID lows of March 23, 2020, there have been a multitude of TV shows and webinars that have the common refrain:

  1. The markets are always right, and
  2. The markets are forward looking.

These statements are repeated so often that they have been taken as gospel truth.

If markets were always right, then they would never change direction. If the markets were positive about a stock then that stock would always be ascending and would never reverse course. That rarely happens. Every stock has a reversal - sometimes momentarily, sometimes for a longer period of time.

Secondly, if markets were always forward looking and - by extension, also right - then there would really never be any correction of any kind because the forward-looking Mr. Market would have correctly predicted the future and all the good news (or the bad news) would be priced in at this very moment.

The fact is - from all the squiggly graphs that you see for every share or every market index that has ever existed - the markets are not always right and they are not always forward looking.

The markets react to information and then create a hypothesis based on that sliver of information. If a pharma company announces trials for a vaccine for COVID, the market takes that as positive sign and assumes that the trial will be successful and the vaccine will be available within a few months. It then prices in the scenario of a COVID-free world. Many times that assumption is proved wrong.

Flows, fundamentals, and foolishness

There are primarily two forces that drive the price of every stock:

  1. The flow of money, and
  2. The fundamentals - or the underlying ability of that business (represented by the listed share of that company) to earn money.

Depending on whether you are a trader or a long-term investor - or a speculator buying on a hunch - you will have different time horizons for "your version" of the share price. Sometimes that may agree with "the market", many times it will "not". The profit you can make is the difference between your version of reality and the markets version of reality.

A trading or investment opportunity occurs when the two realities are not the same.

The world has been in a very strange place since the outbreak of COVID-19. In the past 9 months, the flow of funds (as represented by the printing of money by the central banks around the world and the government handouts to offset the loss of incomes due to lockdowns) has surpassed the flow of funds over the previous 12 years! That ferocity of money - like water gushing out of a fire extinguisher - has lifted stock markets to levels with a velocity that is only matched by the growing number of COVID cases.

An old saying of "Don't fight the Fed" is more apt that saying the markets are always right. If the Fed (the central bank of USA) and other banks are printing money, then markets will be buoyant. You should not fight that Fed pumping for sure by, for example, going short in a rising market. That can be very painful. As traders know, "the trend is your friend" and you go along for the ride. Until the trend reverses.

The flow of money argument is a fair and legitimate one. The argument that the markets are forward looking and therefore accurate is not. One can be forward looking based on hope, not fact. And when the hope is belied and the fact emerges into a reality it can be a rude shock and make one look foolish.

A quick, back-of-the-envelope calculation in March suggested that India's economy will shrink by 10% for the year-ending March 31, 2021. A more detailed analysis gave way to different scenarios and a more measured view that the economy could shrink by between 4% and 10%, under various scenarios. The recovery of many sectors (tractors and 2-wheelers) and the continued hit on many others (airlines, hotels) will play out over the next few quarters with bumps along the way. Though economies around the world have "opened up", the virus is still around, It has not gone away.

My "forward looking" view on COVID was that by June end it would disappear (as SARS had in 2003). Later, I punched some more assumptions into my xl sheet and said "July 28, 2020". By July I felt foolish and gave up. The world had opened up: this meant that humans were moving around. Which meant that the virus was moving around - faster than the humans could (it's "R" factor of transmission is greater than 1.2x).

The good news is that the virus may have weakened or that we know how to treat people who get infected by it. In the early days of the COVID pandemic nearly 8% of the people infected were dying from COVID. Now, the number of deaths is closer to 1.2%. This is still high: the seasonal flu kills 0.2% of those who get infected every year. So COVID is still 6x more lethal than the seasonal flu (which has a vaccine, modified for a new strain every year).

Hopes of a vaccine still persist. But calculations suggest that to vaccinate 8 billion people eventually - or even the first few billion - will take years. This means that we either step back into some reclusive lock down or totter about warily.

The permanent damage of the virus is the dislocation of balance sheets of households, companies, banks and governments. Many will never make it through to the other side.

There will be winners in the stock market for sure.

But many companies will be losers.

This is a long haul. The outcome will eventually be a victory and we will return to a normal life. But don't expect the 60% surge in stock market indices to sustain or even extend. Don't get swayed by bravado and headlines. We are all sitting in a bus being driven in the night on a hilly road with the headlights off. Stay invested with 3 parachutes: a mix of equity, liquid funds and gold. One of them will save you from excessive pain.

Suggested allocation in Quantum Mutual Funds (after keeping safe money aside)

Quantum Long Term Equity Fund, Quantum Equity Fund of Funds, Quantum ESG India Fund Quantum Gold Savings Fund Quantum Liquid Fund
Why you
should own
An investment for the future and an opportunity to profit from the long term economic growth in India A hedge against a global financial crisis and an "insurance" for your portfolio Cash in hand for any emergency uses but should get better returns than a savings account in a bank
Suggested allocation 80% in total in both; Maybe 15% in QLTEF, 10% in Q ESG and 75% in QEFOF 20% Keep aside money to meet your expenses for 12 months to 3 years
Disclaimer: Past performance may or may not be sustained in the future. Mutual Fund investments are subject to market risks, fluctuation in NAV's and uncertainty of dividend distributions. Please read offer documents of the relevant schemes carefully before making any investments. Click here for the detailed risk factors and statutory information"
Disclaimer: The Honest Truth is authored by Ajit Dayal. Ajit is Founder of Quantum Advisors Pvt. Ltd. which is the Sponsor of Quantum Asset Management Company Pvt. Ltd – the Investment Manager of the Quantum Mutual Funds. Ajit is also the Founder of Quantum Information Services which owns Equitymaster and PersonalFN. The views mentioned herein are that of the author only and not of Quantum Advisors, Quantum AMC or Equitymaster. The information provided herein is compiled on the basis of publicly available information, internally developed data and other sources believed to be reliable by the author. The information is meant for general reading purpose only and is not meant to serve as a professional guide / investment advice for the readers. Readers are advised to seek independent professional advice and arrive at an informed investment decision before making any investment. Whilst no specific action has been suggested or offered based upon the information provided herein, due care has been taken to endeavour that the facts are correct, accurate and reasonable as on date. None of the Author, Quantum Advisors, Quantum AMC, Equitymaster, their Affiliates or Representative shall be liable for any direct, indirect, special, incidental, consequential, punitive or exemplary losses or damages including lost profits arising in any way on account of any action taken basis the data / information / views provided in The Honest Truth.

Equitymaster requests your view! Post a comment on "Markets are Always Right?". Click here!

2 Responses to "Markets are Always Right?"

Gunesh Apte

Oct 30, 2020

Reasonably well articulated thoughts about current situation.
Many scientists & astrologers have been attempting to predict the future of the COVID-19 scenario since as early as January 2020, and none of them have imagined the situation which the World is in today.
There is no point in doing such predictions when in reality humanity can not predict any thing about future. Same is true about Financial markets. At the best, one can have some investing process in place, and stick to it under all circumstances. Having good risk management & asset allocation process is the only thing one can do as an Investor.

Like (2)

Sambaran Mitra

Oct 30, 2020

I am not entirely convinced about gold as a parachute. I read all the articles by Ajit Dayal singing paeans about gold, but I could not convince myself. I am okay to keep a little bit of physical gold so that I can run away with that gold in a small bag in case of 1947-like-partition, a massive attack by China, or similar such stuff. Otherwise, I will de-risk with Quantum-liquid-fund only. Gold cannot be better insurance than safe-liquid-fund. To the argument that gold shows better anti-correlation with equity, I will counter by saying "Do not mix insurance and investment".

Like (2)
Equitymaster requests your view! Post a comment on "Markets are Always Right?". Click here!