To simplify a problem, one effective approach is to decompose it into distinct components and analyze them through the lens of systems thinking.
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In the present article, I examine the equity markets through this perspective. It is worth noting that Dana Meadows, an American scientist, has published a notable book titled “Thinking in Systems: A Primer” that can aid readers in resolving their own intricate dilemmas.
The Indian headline equity indices have flatlined over the past sixteen months. Last week, I wrote that the headline belies the pain beneath the hood; share prices of broader market constituents are badly bruised. With many variables now at play pulling in different directions, let us today look at how should one approach the equity markets at this juncture.
The dissonance stems from the lack of understanding of how dynamic equilibrium (which markets are) operates. In terms of analogy, let us think of it as the level of water in a bathtub with a shut drain and a closed faucet. In such a situation, the level of water stays unchanged over time, thereby creating an equilibrium.
Now let us think of the same bathtub, but this time, open the drain and start the faucet while making sure that the quantum of water flowing in, exactly equals the water draining out. The level of water still stays unchanged, but the situation is vastly different. While we can call the shut drain/faucet – a static equilibrium; the open drain/faucet is a dynamic equilibrium.
A theoretical model can posit that water flowing in equals water flowing out with absolute precision, but in reality, such an assumption is not feasible. Even when dealing with just two variables, such as a drain and a faucet, complications can arise. It is not difficult to imagine the added complexity that would ensue with hundreds of variables. Therefore, I put it to you that, that is what markets are – a dynamic equilibrium with hundreds of variables.
Fortunately, complexity does not always indicate disorder. A brief examination of the chart below reveals a strong correlation between change in earnings and market levels. As earnings for index constituents have increased over the years, the markets have similarly risen. Although there were instances where earnings rose before the markets followed suit, and vice versa, it is reasonable to conclude that the long-term correlation between earnings and markets cannot be refuted.
With that established and looking at how consensus estimates Nifty EPS to rise from cINR694 to cINR877 over two years, why complicate the investment decision? Investing now and relaxing seems to be the logical course of action, does it not?
While that may be the straightforward approach if markets were a static equilibrium, there are issues to consider. The growth of corporate earnings is not linear, given the multitude of variables (such as the global economy, trade, India’s economy, sectoral developments, and company-specific issues) that affect it. Although Nifty’s EPS has increased from Rs 91 in 2003 to Rs 694 in 2022, it has spent six years in the 300 per share range in just the past decade, as illustrated in the chart below.
This is the reason why the markets exhibit cyclical patterns. For instance, the Sensex yielded a mere 1% return between December 1993 and December 2002 (approximately 3,300 days), and only 30% return between December 2007 and December 2016 (again, approximately 3,300 days).
In contrast, the market delivered six-fold returns between December 2002 and December 2007 (approximately 1,800 days) and nearly two-and-a-half-fold returns between December 2016 and December 2022 (approximately 2,200 days). Since the investment community tends to be influenced by recency bias (a cognitive bias that favours recent events over historical ones), there is a tendency to believe that exceptional returns are the norm and that cycles in earnings and the market do not exist.
One could argue that index returns tend to be robust when earnings are growing, and since the consensus expects strong EPS growth over the next two years, would this time be any different? In other words, while it is true that the market has operated in cycles historically, the conditions that existed then may not be present today.
Indeed, except investors are not the only ones susceptible to biases, as analysts are also prone to them. A glance at historical consensus estimates reveals an optimism bias (a misguided belief that the likelihood of experiencing an adverse event is low). The chart below illustrates how consensus estimates start out optimistic but wane as the year progresses.
The line chart depicts the consensus EPS estimate over time, the grey bar chart represents the actual EPS for the year, and the orange bar indicates the percentage decline in EPS estimates from the beginning of the year to the end.
The current issue at hand can be summarized as follows: “Throughout history, there have been periods where corporate earnings (and markets) remained stagnant for several years, and despite consensus estimates forecasting an increase in earnings over the next two years, they tend to be overly optimistic. Furthermore, given that markets operate in cycles, and recent performance has been strong, investors must prepare for potential downturns and not be deceived by their recency bias.”
Almost there, but with one caveat. Even during periods when headline indices are flat, there are still opportunities to generate returns. For instance, during the period when Nifty returned only 30% between December 2007 and December 2016, several stocks in the BSE500 index performed exceptionally well, such as Symphony which returned nearly 300 times.
Certainly, the complexity and unpredictability of the variables that impact the markets make it difficult to predict the future with any degree of accuracy. Attempting to understand each individual variable would likely not improve our investment decisions. However, there are some fundamental principles that we can rely on.
First, a country with increasing labour force participation can expect economic expansion. India is expected to witness this over the next two decades. Secondly, higher GDP typically leads to increased corporate earnings, particularly in India where the organized share of the economy is growing.
However, growth in earnings or markets is not linear, and paying top dollar betting on the probability (which very high PE multiples imply) is unwise. Finally, a flat market does not necessarily mean a lack of investment opportunities, as certain stocks may perform well despite market stagnation.
Cutting the noise helps immensely. Alternatively, we can keep making a complex problem more complicated (as Anderson says) by adding multiple variables, but our investment experience will become quite unpleasant.
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