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Burdened by Overreactions

While the overreacting markets have led to their current downfall, you shouldn't overreact as well

Even though the entire world appears to be heading towards a period of economic distress, it would be dangerous to try and judge the magnitude of the coming storm from the magnitude of the stock markets' fall. And it would be even more dangerous to try and do it on the basis of the media's hyperventilating reporting about the events of the stock markets. Over the last few weeks, as the major stock indices have dropped below one can't-possibly-go-lower level after another, there is a palpable sense of panic amongst people who have any kind of investment. All thumb-rules and projections seem to have broken down and every day brings an increasing sense of disaster. While the magnitude of the economic downturn cannot be predicted, the stock markets are doubtlessly over-reacting to whatever is in store.

Moreover, this overreaction on the way down is as much built into the nature of the markets as the overreaction on the way up was. Understanding this is the key to maintaining one's equilibrium in times like these. It is the job of the markets to try and predict the future. In its simplest form, profits come to those who can foretell tomorrow's (or next year's or next decade's) stock prices. At any point of time, there are conflicting narratives that market players believe in about which way things are going. For some years now, the most dominant narrative has been what is generally called 'the India story'. As this narrative became more and more dominant, it pushed out all those which contradicted it. The result was the 'buying panic' that stocks witnessed at various times during recent years. What you are seeing now is the complete opposite. There's only one story left at this point. Roughly speaking, this says that the world is ending. There's no conflicting narrative left.

It's no one's case today that all talk of a downturn is mistaken. In that sense, the stock market is correct. However, the stock market's correctness is limited to a qualitative sense. In quantitative terms, the stock markets' opinion is worthless. Last week, the BSE Sensex fell by about 1200 points. On Friday alone, it fell by more than 1000 points. It could have fallen by 500 points through the week, or by 300 points each day, or stayed flat through the week and fallen 2000 points on the last day. The predictive value of all these would have been about the same-close to zero. However, the emotional response and the size of the headlines would have been very different in each case.

It's only in the medium and the long-run that stock prices follow the real economy--in the short run, they only follow the money. More often than not, there's money flowing in and out of different sectors and different companies and the net effect is somewhat in one direction. Nowadays, all the money is indiscriminately flowing only in one direction. Whether it's the FIIs selling because they need cash at home or a general panic here, there's no balancing force acting for the time being.

This does not mean that the market knows that everyone is doomed. Rather, this means that the market knows that some are doomed but it doesn't know which ones. So for the time being, it assumes that everyone is doomed. Meanwhile the most important thing is to keep your cool and enjoy a happy and safe Diwali.