Its just mean Baby!

Any trend usually tends to converge to its mean. In stock markets the index which represent weightage average of basket of stocks is no different. Indexes are made of individual stock prices. Stock price is a measure of valuation of the company's business. It simply says what investors are willing to pay for an equal pieces of residual interest in that company's business. Residual interest is the value left for common shareholders after all the debt and other obligations are paid to respective holders. So its a value of the company's business and sum total of all such companies businesses give an indication of what economy of a country is worth, or at least the trend of that economy. That is, if in long run companies are more profitable than previous years, economy would more or less be positive and these companies would attract increasing valuation or higher stock price as time goes. So in a nutshell the trend of economic growth and stock markets growth should co-relate in long term.

Our country's economy is usually measured by GDP numbers. GDP comprises of agricultural sector, services sector and industrial sector. Most of the companies listed in stock exchange are in services or industrial sector which today comprises 80 - 85% of GDP numbers. Thus any trend of stock market index should match the trend of GDP growth. However we all know this is far from true. Stock marks gyrate from huge bullish rallies to great bearish depression. How can we use this gyration to our advantage in making investments decision. Answers lies in 'return to mean'. Any significant deviation from the mean is followed by reversal which converges towards that mean.

Before showing on how this is valid or how we can use it, first let us approximate the mean growth of business of companies which would translate to growth rate of stock market's index. Our GDP would grow at an average rate of 7 - 9% for foreseeable time in future. Even long term average of past 15 years of growth is around these range. We add to that 4 - 5% of average inflation. That makes growth in business of companies around say 13%. Which is roughly the rate at which one should expect stock market indexes to grow.

Now lets see how as our Stock Market's most prominent index, BSE - Sensex has performed since start of 1991.
Blue line is the index value and red line is what index should have been if it strictly followed the 13% growth.
So you can see at times it was greatly above this red line and at times was much below it. However every time is crossed this mean, it eventually reverted.

1992 - 1994 were bullish times followed by a bearish market 1997 to 1998. Markets again turned bullish briefly during 2000 (dot com bubble) and then engulfed in a prolonged bearish market during recession of 2001 - 2004. We again saw economic revival post 2004, thanks to trillions of dollars pumped into the market by central banks across the world. This money trickled into India via FIIs and then we saw an unprecedented bull market which lasted till 2008. During this time markets deviated from its mean like never before. What was the result, as markets deviated from its mean like never before, they fell towards that mean like never before. The recession of later half of 2000 caused panic worldwide. If somehow we could have avoided the temptation to commit ourselves at start of 2006 when this frenzy began and had lot of patience then we would have again had the oppertunity to make some wonderful investments three years later. Anyway hindsight is always 20/20, but does offer some lessons.
Come start of 2009, we were at last seeing some sanity towards valuations of companies. However they were still not at those juicy level witnessed in 2002 - 2003 (just look how low below mean markets fell that time). However this sanity lasted only few months, thanks to next round of even bigger chunks of money pumped by the very same central banks. Much of this money was pumped in to revive the economies worldwide and now this money is moving into the emerging markets like India. As you see markets have again bounced back away from the mean. So when would they return back to the mean, no one knows, but as history has shown they eventually would.

As an investors what we can do is, be wary of lofty promises and projections made by some companies to eat up this new pumped in capital. You would get a chance in future where once again you could buy pieces of wonderful businesses at attractive prices. There are good businesses around even now, however your returns from investments are largely dependent on the price you pay. If you are paying too much price for a piece of good business you may still loose money or better still your recovery horizon may last far longer than hoped for. So by stretching the time, why lower the rate of return.

I think what has been mentioned so far is nothing new. It has been iterated many time before and is something very simple to understand. So is investment, its simple but needs lot of temperament and patience. Its very easy to be swayed by next bull market, by looking at your neighbor making pile of money by dabbling in worthless stocks, but that's not a winners strategy. What would lead you greater wealth is stay clam, have a realistic expectations and do your homework right.

Remember:
It is more important to say "no" to an opportunity, than to say "yes".

Sachin