From the start of the year, a business TV programme editor wrote me numerous mails to have me as a market commentator during my next visit to London, Delhi or New York. After I finally made it to the hot seat, it turned out to be a brief affair.
TV host: Mukul, what is your view on the market?
MP: We are long on the market.
TV host: Why is that so?
MP: Because, Indian markets have underperformed its global peers and this underperformance should reverse and lead to performance.
And, it was over. It took me a while to realise that our work on mean reversion did not generate causal explanations. The mind is strongly biased towards causal explanations and does not deal well with “mere statistics”. There is an insistent demand for causal interpretations. When our attention is called to an event, associative memory looks for its cause and causal explanations are evoked whenever regression is detected.
According to Daniel Kahneman (Nobel Prize 2002), humans love this narrative causality. “However, the explanations are wrong because regression to the mean might have an explanation, but it has no cause.” Regression is a temporal event. In his book, Thinking Fast and Slow, he explains mean reversion and how society pays people quite well to provide interesting explanations of regression effects. A business commentator who correctly announces that “the business did better this year because it had done poorly last year” is likely to have a short tenure on the air. The phenomenon of regression is strange to the human mind. Simply putting, mean regression suggests “what goes up comes down and vice versa.”
It’s this love for narrative causality that keeps us hooked to the “love thy Nifty” spell, so much so that the talk of Nifty and 5,000 can be an endless market saga. We are not in the 1980s when charts were made on graph paper and market cult had few followers. Today, 5,000 psychological levels don’t mean much. Markets are much more complex now, compared to the 1980s. It’s my belief psychology attached to round numbers is a redundant thought. If psychological numbers were important, prices would trend when the respective levels were broken. In the last 34 months, Nifty has crossed 5,000 a total of 17 times. How can a key psychological level be tested 17 times and still be important?
Above this, if a section of the market is a zero sum game—i.e. someone’s gain is someone else’s loss—manipulation to some degree should be a legal process. Keeping this is mind, don’t you think that after 12 quarters of struggling above Nifty 4,700 levels, the bears won’t give it a last short to break 4,700 and rake in some real profits. What better time for a bear to change into a bull, after 4,700 breaks and prices head to 4,500?
The breakdown would create more panic, generate a cheaper entry, dig a bigger trap, a result in a larger reversal.
Though talking about volatility is sensationalising, which a columnist or TV commentator should avoid, our objective here is to help you identify a potential risk. The best part is that there is a way to hedge against this potential volatility. This brings me back to my brief incomplete TV interview. Worst performers not only statistically illustrate extreme reversion, but are also less correlated to market movements. We are long on the market, with 30 components which are the worst performers in the BSE 500 and the lower the Nifty goes, the better it should be for accumulating depressed valuation stories. This offers a natural hedge to a portfolio. We love the worst outlier stories and prefer to be cautious when the only excitement is a green Nifty above “psychological” 5,000.
The author is CMT, and Co-founder, Orpheus CAPITALS, a global alternative research firm