India's GDP slips down 23.9% in first quarter (Apr-Jun) of 2020-21
We are sure you have read these headlines that for first time in four decades the GDP registered a negative growth. Defies all logic that the stock markets are rallying despite poor health of the economies across the globe? In this newsletter we’ll try and uncover the contrast in stock market and economy patterns and the probable reasons behind this scenario. It’s more than obvious that the stock market and economy set our minds to swing when it comes to investment in these unpredictable times. Apparently, the three facets of economy, stock market and mindset are proverbial pendulums that are incoherently swinging. It is indispensable to decipher a relative equation between these three pendulums before we invest our hard-earned savings. Apropos, we will try to understand how these dynamics affect our investment mindset and how to navigate through these unpredictable swings. Our 6th standard physics teacher taught us that a pendulum oscillates in motion unless interrupted by an outside force or what’s popularly known as “concept of oscillation”. A pendulum is a weight suspended from a pivot so that it can swing freely; that’s what Galileo Galilei (1564-1642) told us way back in 16th century.
Economy: The First Pendulum
The economy oscillates between expansion and contraction like a pendulum (assuming the equilibrium position as base at a particular point in time). For this article’s sake let us say, when the pendulum swings to right, the economy is expanding and when the pendulum swings to left, the economy is contracting. Now, we need to note that this 1st pendulum is a slow swinging one, and can remain one sided for multiple years depending on the economic environment in the country. The pendulum describes a directional movement where forces of change swing back and forth between two extreme poles in fairly regular time intervals. How? Good governance, economic activity, more investment, more productivity can help you keep this pendulum on the right. While bad governance, economic fallout's (COVID pandemic), policy lapse, etc can dramatically swing this pendulum to the left. Something that we have witnessed recently. In the current context, the economy is contracting, and not by small numbers, a whopping -23.9% contraction because of COVID. Read here! Yet the investor confidence being reflected in the market was at an all time high. The stock market has been rallying like it’s running on steroids and a large number of shares have reached an all time high in a matter of months from the COVID fallout. This bring us to our second pendulum.
Stock Market: The Second Pendulum The stock market is or was supposed to be the barometer for measuring the economic activity. Remember the device that we studied from our Physics teacher; it could measure air pressure. By all standards, either global warming is changing the air around us or the barometer seems to be broken. Or does it? In an ideal case scenario, the 2nd pendulum should overlap with the 1st and mirror the economy as a true reflection of its barometric functionality. But this pendulum is notorious and fluctuates dramatically from the economy owing to multiple factors. This diverse fluctuation creates a divergence between the stock market and the economy. Let us understand how and why this happens! 1. Class Representatives: The stock market is actually not representative of the entire economy but a collection of few top performers, analogous to class toppers who represent the entire class. For instance, the Nifty 50 is a collection of top 50 companies based on free float market capitalization. Each of these 50 stocks have a certain weightage in this index (Nifty 50) and their price movements affects the movement of Nifty 50 index. To understand weightage average, consider how the class topper skews the class average marks up as she always had to score 100 marks. The index weightage average works more or less in the same way with a few more technicalities. Right now, the class topper for our Nifty 50 is Jio Mukesh Ambani. The Reliance Industries carry a whopping 13.63% weight in this index of 50 companies. And reliance’s share prices have more than doubled from its lows in March. Do you get the context?
Here's the list of five nifty toppers:
Reliance Industries 13.63%
HDFC Bank 9.99%
Infosys Ltd 7.03%
HDFC (Housing Development & Finance Corporation) 6.55%
ICICI Bank 5.62%
Source: NSE as on 31st Aug 2020
So, the market rally is actually a rally in the few select stocks and not all of the 6500+ stocks listed on both NSE and BSE. 2. Everyone wants a piece of the pie: Stock markets move between extreme optimism and pessimism which are two extreme ends of the second pendulum While the entire nation went on a complete lock down, keeping the stock market open paved the way for people idling at home. Our country witnessed a tremendous surge in the number of individuals investing in stocks during the course of the lock down. A record 1.2 million people opened their Demat account in March-Apr 2020 And when market began to rally, everyone wanted a piece of the pie. Brokerage firms reported a rapid rise in the number of clients as more investors decided to dabble in stocks while they stayed indoors with more free time. The surge in this number was not only attributed to the opportunity created during the lock down, but also deviation from traditional investment vehicles that are no longer able to create sustainable returns over and above inflation. Do you remember our 3rd commandment of investment (from the previous newsletter) - Don’t forget the mighty inflation! Read again here! 3. Liquidity: Did you have loads of cash resting at your house during demonetization back in 2016? Well we hope not! Having sufficient free usable cash with you at hand or in the bank is your liquidity. The same applies to a country and its economy. When there is sufficient amount of disposable liquid money in the system, economy is termed as ‘high liquidity’ or easily put, free money available for expenditure. The stock market rebounded sharply from lows to highs, credit the high gush of liquidity! To uncover why liquidity is so important in influencing the movement of the 2nd pendulum we have two parts to it. One is what creates liquidity, and second how does it ultimately drive the markets? One: We saved a lot of money during the lock down, lets confess it. For the class of employed people or businessmen whose businesses weren’t shut during the lock down, there was a constant stream of money flowing with no outage. This increased the retail consumer level liquidity. Also, given the precarious economic condition, governments pumped money in the economy by various mechanisms (topic for another day) to drive the economic engine faster. For reference consider that US Federal Reserve (analogous to RBI in India) pumped approximately $ 3 Trillion in their economy (That’s India’s GDP). We will let your jaw drop for a moment! Two: With excessive liquidity, consumers & organizations look for avenues to utilize this money. And what better to utilize your money than grow it. Unless you fantasize putting it under your mattress.
With limited options to invest, stock markets have become the place to actually utilize this liquidity. And not just the retailers, but even institutions, banks, everyone is trying to take a piece of the pie. The behavior of the second pendulum We will take this opportunity to take you back to the historic month of March 2020, when the market had corrected by almost 40% with many stocks correcting as much as 70-80%. But wait a second, didn’t we read that our GDP has contracted by almost 24%. Isn’t that a divergence opposed to what everyone is talking about? Has the stock market corrected more than what the actual economy has witnessed? This brings us back to the point that the stock market is the more volatile pendulum, and its swing can not only skew to the right, but also to the extreme left at times. And why does it behave that way? Here comes the 3rd Pendulum to make a more rational explanation to the not so rational human mind.
Mind: The Third Pendulum The human mind is the only pendulum in your control, the other two are out of the scope of your personal investment syllabus. But despite being the only pendulum in our control, it swings wildly between our plethora of emotions. The extreme divergences of the stock market are driven by the collection of irrational humans who adhere to extreme optimism or extreme pessimism. Here’s an illustration of the human mind and the emotions we dabble with in the market.
Based on the illustration above and our explanation of the behavior of the three pendulums, here’s our 2 cents in conclusion to this newsletter: Our 2 Cents: Your ability to differentiate from average irrational human behavior will significantly improve your chances of being a better investor.
i. Understanding the herd behavior driven by the emotions in the market, we need to take a cautious step and chart our way forward. For e.g. Euphoria and depression be
come your points of exit and entry respectively. Master your emotions!
ii. Remember the physics of the pendulum. A wild swing to either extremes will always be followed by a retraction to mean and swing to opposite side. Meaning? If market either falls to extremes (identify the emotion of public), it will always swing back through equilibrium and beyond That's all folks. We hope we were able to throw some light on the mystic question. The next time you end up having a discussion on divergence of stock market and economy, you have an arsenal of pointers on your side. See you next week. Until then share and help us grow with your love!