Market gyrations even out in long term

There were many dire predictions about the equity market in the wake of demonetization –same day as Trump’s victory! Some of these predictions even looked correct and sounded intelligent when we read it. It was proved right when we saw the S&P 500 immediately collapse 5% on the evening of the election results. I saw my own portfolio fall by about 4%. Then, miraculously, the S&P 500 came right back and is about 2% higher than the election day! I got a chance to buy some fertilizer shares, IT, airline and NBFCs at low prices. Like all fair-minded people, I hope that it has a good impact on the legitimate part of the economy.

Global stocks too have not changed much in the aggregate and emerging market stocks are down almost 10% over this period. In fact, I bought IT shares because I saw the US dollar strengthening - and of course, it had nothing to do with demonetization. So, depending on which markets of the world you invest in, these predictions could have been right or could have been wrong.

Market commentator Barry Ritholtz says that this proves we don’t “know anything” and that “forecasters are terrible”. Such comments are probably true to some degree, but it does not mean we should not forecast at all. The short-term forecast is far more difficult to make - it depends on the investing behaviour of almost the whole world. However, in the longer run the market is a clear slave of earnings per share (EPS), private equity (PE) and the reputation of the management. The only and the real lesson from the market’s reaction to any event is not that forecasting is stupid or wrong or nobody can do that. The real lesson is — no one knows what shares/ bonds will do in the short-term and good research people think in terms of probabilities, and think micro.

Increasing the time horizon reduces the randomness of the share market’s negative performance because you’re improving the odds that your portfolio’s performance will correlate with the EPS, currency, and PE that your portfolio deserves. Foreign institutional investors (FII) inflows do play an important role, but that number is available on a day to day basis - and allows you to react. Since good companies do well, and pay out cash as dividends over the long term, share valuations tend to reflect this. The share price movement of Infosys and its earnings growth is a perfect congruence - not just a look alike. Look at trying to predict the long-term performance of a 10 year G-Sec. Try predicting its day to day price over the next 10 years, and you will fail miserably. However every investor knows that interest and maturity amounts will come on exactly the same date on which it is due. By increasing your time horizon you remove overreactions of media guessers.

The intelligent investor cannot ignore company forecasts or assume that everybody is guessing. Instead, they should apply a sensible approach to Excel models and use probability more than fixed formats and do it over a realistic time horizon. I might not (actually do not) know what the market will do today, tomorrow or next year, but I know that equity is a long-term instrument that will have a high probability of paying out positive future cash flows if I hold it for a long enough time horizon.

LUCRATIVE BETS

1. Increasing the time horizon reduces the randomness of the share market’s negative performance
    
2. This is because you’re improving the odds that your portfolio’s performance will correlate with the EPS, currency and PE that your portfolio deserves
    
3. Foreign institutional investors inflows are crucial but that number is available on a daily basis

The writer blogs at www.subramoney.com