Intermarket cycles can redefine investment strategy by identifying sector leadership and the stage of the economic cycle.
Majority of us, think more about where we are right not about when we could be wrong. Admitting and studying mistakes is the first step we fail to take as a society.
There is one more reason, the human society fails to see leadership of an idea, a thought, a movement or in other words an asset early in its life cycle is because we suffer from short termism, investment myopia. We look at immediate financial gratification. We lack patience. We don't plan our investment life over the process of ten years, but over a few weeks or few months. The frantic speed of growth of the neighbor's car or mutual fund holding is what inspires us more and motivates us in investing recklessly.
This is one of the reasons we fire the same CEO's we celebrate months ago on Euromoney covers. Look at the magazine covers, starting January 2007 most of the fallen heads are crowned there. And many of the structured products published in glossy pages have reached junk status.
If the head of a leading mutual fund can say in January 2008, "I don't think investors need to worry about correction at this stage. I believe that the Sensex will touch 40k", you can excuse all the other experts. Vis-a-vis this, our (Orpheus) targets of 24,000 were just 13 per cent above the actual Sensex top made in January.
In any case, if we the "experts" are so miserable in understanding leadership, how effective are we together as brokers and analysts in wielding tools of measurement.
The process of miscalculations is not limited to experts. We have world's best index construction companies and exchanges mistiming an entry and exit of a stock from the popular indices.
The world's best known index the Dow Jones has seen the auto major GM crash from 95 to 8.82 in less than 10 years. We can also debate index components in Sensex and the Nifty. How components are selected and why they are taken out?
Sun Pharma, an Indian pharma major that tops the performance ranking in blue chips over the last 12 months with returns at 17 per cent has showcased secular outperformance over its sector peer stock Ranbaxy since 1998. We can debate the free float factor etc. But leadership measurement does remain subjective rather than objective. There are more examples from emerging market Indices, which are filled with stocks that underperform their sector peers. There are even examples of stocks shining and returning triple digit returns after being expunged out of Indices.
What this tells us is that popular benchmarks may not necessarily be good in identifying and filtering out market leaders. And endless discussion on stock selection may not help. Markets and sectors mature in time and tight performances between sector peers can be explained better statistically and cyclically than otherwise.
The classic pair of Infosys and Satyam is a tight performance pair. You can write a case about how different these two companies are and write tomes of analytical write ups on the same, but in reality the one year, six month, three month price performances are similar irrespective of a different business strategy that a business might seem to follow.
But then like Soros said, "I'm only rich because I know when I'm wrong". We can attempt understanding why, where and how we are wrong in identifying leaders. Leadership can be micro and macro. It is micro in terms of stocks and macro in terms of sector.
Leadership can also be regional and global. Regional in terms of Indian markets compared to the South Asian markets and global in terms of equity leadership vs. other global assets. Leadership is about performance and reward. And performance like we have mentioned is relative and cyclical.
In 1923, Joseph Kitchen identified a shorter periodic movement that is often described as the inventory cycle or the 40 month cycle. According to an article written by W.W. Rostow, University of Texas, cycles are the form economic development takes under capitalism. The study suggests that a business cycle is basically a sectoral phenomenon with macroeconomic manifestation.
Studying markets without understanding leadership or performance cycles is an incomplete study. New advances in mathematics have already proved that market prices and everything linked with nature exhibit a power law. And considering economic cycles also express power law behaviour (3.3, 10, 30, 90 year cycles), sectoral components should also be connected in performance and leadership with some fixed periodicities.
We researched on the same and found a validating case. ACC-Ambuja, NALCO-Tata Steel, GM-Ford (American auto majors), ICICI Bank - HDFC Bank, JP Morgan - Bank of America (American banking majors), Satyam-Infosys, Wipro-Infosys and a host a sector peers exhibit a 17-20 month performance cycles on a short time and 34-40 months over the Kitchen Cycle.
What does this mean? This means that the cyclicality and performance of markets are a sine curve and every few months, you can chose performing leaders for your portfolio. The intermarket cycles work also suggests that popularity of a certain stocks does not necessarily reflect in their actual price performance.
There are more interesting observations that can be made once you start looking at intermarket sectoral pairs. Emerging markets have more volatile intra sectoral inter peer performance. While developed economies have very tight non-differentiable pairs, owing to wide tradability and market comprehension.
This international interface also rubs on Indian technology making the pairs tight in performance. There have been occasions when some stocks simply break off the inter peer up-down cycle like a tangent. A tangent higher are the real innovation sparks, where stocks are changing course and redefining sectors and maybe creating new sub sectors. And the tangents down are the disasters waiting to happen. Merck vs. Pfizer case highlights this. And without innovation and dramatic action, the disaster can be fatal.
News and stories fulfill a psychological need. But the story becomes uninteresting when it repeats and challenges conventional beliefs. Intermarket cycles like Elliott might be perceived as repetitive gibberish, as it trashes conventionalism, but the fixed periodicity highlighted by Clement Juglar (7-11 years) cycles in 1860, Joseph Kitchen's inventory adjustment (3-5 years) business cycles published in 1923, and Brian Berry's refinement of Simon Kuznets (15-25 year) cycle work on construction and demographic factors into a (25-35 year) investment in infrastructure cycles in 1991 have stood the test of time.
The only problem is that the world today cannot wait for 17-20 months to see if a few of the filtered outperformers delivered or not.
In the same article which talked about topping of markets in January 2008, we also said, "Selling in strength isn't easy. We advise to reduce capital goods sector allocations and looking into pharma and FMCG (fast moving consumer good) majors, which we consider defensive plays and emerging outperformers".
The top four gainers of India, year till date consist of two pharma majors and one FMCG major HLL. But then, seven months is a long time to talk about an old story.
The author is CEO, Orpheus CAPITALS, a global alternative research firm
