BackWhat the stock market taught us in 2016
The eventual impact of demonetisation on earnings growth is difficult to predict, but it won't be the non-event that current forecasts seem to indicate
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The second half of December lends itself well to introspection. The activity levels in markets die down as participants close their books and embark on a fortnight of travel, meeting family and friends and merry-making. Yes, there is a flurry of reports on what the coming year is going to look like and strategies to navigate it but this time can be better spent thinking about what the markets taught us in the year gone by. To quote from Thomas Friedman’s latest book: “The ancients believed that there was wisdom in patience and that wisdom comes from patience. Patience wasn’t just absence of speed. It was space for reflection and thought." In that spirit of look-back, here are 10 things that we learnt (sometimes the hard way) from our teacher. To be fair, some of them are eternal truths, but forgetful pupils that we are, oftentimes we need to be reminded.
The most conspicuous casualties of this year were pollsters who failed to predict the two big binary events—Brexit and the outcome of the US presidential election. As Jason Blakely observed in his piece in The Atlantic, “The forecaster on The New York Times home page showed 85% chance of a Hillary Clinton win at the beginning of the election night only to swing to a 95% (Donald) Trump win in a few hours."
There is a lot of soul-searching going on in the field of political science but as we had written earlier, the core of the issue is that human behaviour does not lend itself well to pure science-like modelling. Attempts to quantify human behaviour with mathematical precision are at the heart of social science’s “physics envy"; one can predict the trajectory of a projectile with reasonable accuracy but not the vagaries of human behaviour.
While pollsters not getting it right was obviously a problem for a trader looking to bet on event outcomes, what compounded the problem was that market reaction to the “surprises" was totally surprising too. In the week of US election results, the Dow Jones index was up every single day—the first two days because it looked like a shoo-in for Hillary Clinton and the next three because the markets viewed a Trump presidency positively. As Howard Marks put it in his memo: “Whatever was good for the market yesterday, its polar opposite was good for it today." That’s why, tempting as it may be, it’s better not to trade binary events.
At the peak of a consensus trade, nobody has the breadth of imagination to envisage what can possibly go wrong with it. Everybody agrees on how strong the rationale is and there isn’t a speck of risk on the horizon. Through the year, everybody (including us) was gushing about how compelling it is to buy shares of non-banking financial companies (NBFCs). That’s when this curve ball called demonetisation hit us and what were made out to be structural benefits, like the ability to have deep reach and effectively collect loan repayment instalments in cash, suddenly became the nemesis for the sector. To be sure, the last innings in this game hasn’t been played yet but this is no longer a consensus trade. The lesson here is to be disciplined about valuations when things clearly get over-extended. Towards the middle of the year, valuations for NBFCs had gone into uncharted territory. All the reasons for reversing the winning trade may not be evident then, but bear in mind that as things get heated, the odds are increasingly stacked against you.
Periodic bouts of volatility are part and parcel of investing. But as far as India is concerned, the playbook for volatility in the past has been large capital outflows, significant currency weakness and investors piling into the export-driven technology and healthcare sectors. This may not be the right template this time around. For one, despite capital outflows, the rupee has held up reasonably well against its peers, and both the technology as well as healthcare sectors are facing challenges of their own. Conditioned responses to volatility may not work every time.
For most of their history, oil marketing companies (OMCs) were shunned as mere trading stocks due to lack of independence. One punted on inventory and currency fluctuations or subsidy-sharing shenanigans and, consequently, made or lost a quick buck on them. That template of analysis changed a couple of years ago when these companies were freed from the shackles of subsidy-sharing and the government, to its credit, dutifully allowed free pricing for their products. The return on equity (ROE) ratios that were languishing in single digits suddenly got into the twenties and, from being punts, the stocks morphed into core holdings in portfolios. In 2016, these stocks have stood out as islands of absolute return in an otherwise listless market. But even today, we find a healthy degree of scepticism in this metamorphosis, especially from investors of a slightly older vintage. It’s natural that past experiences and prejudices will weigh on decision making but being flexible about your convictions when presented with new facts was John Maynard Keynes’ sage advice. It still holds true.
One of the most abused terms in investing is possibly “a long runway for growth." India is a very promising market for almost everything if the measure of future potential hinges on a per capita metric, given the sheer size of its population and relatively low levels of income. Yet the markets are littered with carcasses of companies that were operating in these hugely promising areas. A long runway of growth can’t be the sole investing rationale and one has to be prepared to roll up the sleeves and focus on company- and sector-specific metrics. Every year, we scratch our heads about at least one company or sector that had everything going for it from an opportunity standpoint but just failed to deliver. One such example this year is stocks in the alcoholic beverages sector. Favourable demographics, changing attitudes to alcohol consumption, rising urbanization, etc. made the top-down story very alluring, yet the stocks simply failed to deliver as other idiosyncratic issues held sway.
In times like these, one feels a palpable sense of despondency even with hard-core stock pickers. As the slightly older generation of cricket lovers will remember, at 100 for 5 in an overseas Test match it seems all is lost, and then the crisis man V.V.S. Laxman appears at the crease. We feel themes like beneficiaries of pollution reduction and control or the data consumption boom will admirably endure through this period of gloom. The fact that even in a year with near-zero market returns, city gas-distribution stocks have done remarkably well, is testimony to that.
The most telling reaction post Brexit was from a London-based friend who, apart from lamenting the outcome, went on to say that he didn’t know of a single person who was likely to have voted “Leave" and hence felt that the outcome was rigged. This is what we called the “echo chamber" in one of our earlier essays. We tend to be surrounded by people who are like us and share our world view. Social media accentuates this by tailoring our news and opinion feeds to match our preset views. To avoid falling into this homogeneity trap, one needs to seek out and dispassionately engage with people whose views differ from your own, and that’s true not just for current affairs but your favourite stocks as well.
demonetisation has been the most talked-about event in the last couple of months. Forecasting the effects of such unprecedented events is understandably challenging and, predictably, analysts have opted for the status quo. Thus FY18 earnings growth for the Sensex that was forecast at 18% pre-demonetisation is now forecast at 18.6%, while that for FY17 has been marginally cut from 13% to 11%. If this indeed comes true, all the brouhaha would have to be filed under much ado about nothing. What the eventual impact of this move on earnings growth will be difficult to predict, but one thing we are sure of is that it is not going to be the non-event that current forecasts seem to indicate.
We close with a slightly philosophical lesson. People with a passion for the markets tend to get totally consumed by this animal. All of us have frantically hit the “refresh" button on our little screens at 9.15am but as we grow a bit older, we realize that there is a lot more to life than the daily gyration of the indices. Psychologist Amos Tversky puts it nicely: “The secret to doing good research is always to be a little underemployed. You waste years by not being able to waste hours."
So take a step back, cultivate a sense of detachment, tick off some items from the bucket list and be prepared to have a good laugh even if it is at your own expense. Find some time to enjoy a sunset and smell the flowers. Odds are it will make you a better investor. Best wishes for a great 2017!
Amay Hattangadi and Swanand Kelkar work with Morgan Stanley Investment Management. These are their personal views.
Comments are welcome at views@livemint.com
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