Don’t rush to invest

Good second-quarter results may help improve sentiment

Reflexivity is an idea that George Soros drew from philosophy, and adapted to explain market sentiment. The philosopher Karl Popper used reflexivity to explain feedback loops that influence and reinforce social situations.

For example, movies versus reallife. Onscreen behaviour reflects prevailing fashions, social attitudes, musical tastes, etc. But audiences are influenced by what they watch onscreen, and often adopt fashions and behaviour drawn from the pictures. This is an example of reflexivity - movies and real-life influence each other.

Cause and effect blur in such reflexive situations. In financial markets, reflexivity arises when investors see that prices are going up and hence, they start buying, thus driving prices up even further. Once that cycle reverses, and prices start falling, investors sell into the falling market, causing even steeper falls. Momentum is an example of reflexivity.

So, the boom-bust cycle is driven by reflexivity and it does explain why financial markets are rarely very close to ‘fair value’. A believer in reflexivity will assume that trends will pull markets a long way from fair value before any given trend reverses. A Soros follower will therefore, wait until prices are well below fair value before buying, and also wait for prices to rise well above fair value before selling.

Reflexivity would be disputed as a hypothesis by those who believe in equilibrium and the concept that prices will revert to a central valuation, close to the theoretical fair value, whatever that is. Actually both ideas could be partially correct. Prices revert towards fair value some of the time, while also trending away from fair value some of the time due to reflexivity.

Valuations on the major market indices - the Nifty and the Sensex - have averaged out at price-to-earnings (PE) ratio 20.35 over the past 13 years (since Jan 2005). In the past five years, valuations have averaged out at PE 22.7. ‘Fair value’, if we're looking purely at interest rates, is closer to PE 12-14, given that GoI yields have been in the zone of 7-8 per cent. Valuations that low have very rarely been attained in the 21st century.

Let's assume that ‘fair value’ from an interest rate perspective is unlikely to be attained, since it so rarely seems to be. We could pragmatically assume the mean/median (these are close to each other) to be the fair value. In the case of the Nifty, therefore, the fair value is somewhere between PE 20-23 for a ‘pragmatist’. Valuations below PE 20 occur quite often.

Right now, the index is trending at around PE 25, which is much higher of course. A ‘ value investor’ would advise waiting until the index falls below 22 before looking to increase stakes in large-caps. A reflexive investor would look for a fall considerably below PE 22 before getting into buying mode.

Looking for some degree of symmetry, the Nifty peaked out at PE 28.7 and it has a standard deviation of 2.7 in the past five years. A reflexive investor would expect a correction to last until at least PE 20, and probably until PE 17-18, or somewhere between one and two standard deviations below average.

The vast majority of stocks have corrected more steeply than the large caps of the Nifty. Even the Nifty Next 50 (or Junior), which consists of large caps, has corrected quite a bit more than the Nifty. If we adjust for consolidated earnings (the NSE releases PEs calculated on standalone earnings), the Nifty is at around PE 22. There is a case already for selective investment.

However, historical patterns suggest that the Indian market is deeply reflexive. Once stocks correct by 10 per cent, they are more likely to correct by 30 per cent than to bounce back immediately. In addition, the macro situation is looking a little shaky, due to high crude prices, a falling rupee and low GST collections. The debt market has been bearish since mid-2017 and the IL&FS defaults have hit it hard. Plus, there are upcoming elections, which adds a dollop of policy uncertainty.

So, I'd go with reflexivity and wait for a steeper fall, before committing large sums. One point to remember is that lower PEs could also be the result of stable prices plus rising earnings. The Q2 results should be good, given a lingering base effect from a weak July-Sep 2017. Good Q2 results could help turn sentiment around.