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The end of trends

Those who think that riding trends in the market is a surefire way to make money can't be too lucky for too long

The end of trends

The never-ending seesaw of the stock market has put the Indian investor in a particularly confusing situation right now. It's a time when trends are shifting and reversing, the fundamentals of some important sectors appear to have reversed permanently and some of the biggest names in business appear to be heading for a future when they won't be big names at all.

It's characteristic of equity investors that we love trends. Once we recognise it and start making money out of it, a trend is a comforting thing, a solved problem. It assures us that the past can be simply extrapolated into the future and money can be made in this simple way. A great example has been the bull run in small- and medium-sized stocks over the last three years. In early 2014, small-cap and mid-cap stock prices parted ways with large-cap ones and started zooming upwards. Pretty soon, this became a reliable trend and equity investors fell in love with this simple idea.

Since that time, there has been only a brief period in the first quarter of 2016 when this trend hit a speed bump. During that quarter, large-cap indices, the Sensex and the Nifty, did somewhat better than small- and mid-cap indices. Even at that time, the trend made sense because the market fell and smaller companies fell more than the bigger ones. However, pretty soon, the train was back on track and mid-cap indices started gaining more than the large-cap ones. At this point, over the last three years, the Nifty and the Sensex have delivered returns of around 11 per cent p.a., while mid-cap and small-cap indices are in the range of 29 to 32 per cent p.a. Cumulated over the period, that's the difference between Rs 1 lakh becoming Rs 1.37 lakh vs Rs 2.2 lakh. What a wonderful trend!

But what now? Equity investors are a naively optimistic lot. Having made all this money from mid caps, their fantasy would be that this trend should never end. However, all trends end and often quite badly for investors who ride them for too long. In India, one of the biggest roller coaster rides has been that of the IT services industry. The story is too well-known to investors to repeat here, and it seems that the final chapter is being written now. It's possible, though still not certain, that the labour-rate-arbitrage business model of Indian IT companies has run its full life. They simply haven't been smart enough to adapt to the huge changes that are hitting businesses' technology usage.

Of course, there are trends that got derailed because they were just froth built on hype. Infrastructure is a prime case. Sure, India needs and is building a lot of infra and will continue to do so at least as long as Modi is PM but none of that may result in too much joy for investors. The financial shape of the sector is such that apart from a rare L&T, investors may not make any money out of it. Infra was a bubble trend which collapsed soon after it started.

This ending of trends has a proper academic-sounding name, which is 'reversion to mean'. This means that if an asset's returns deviate from its long-term average, then it will eventually return to the average. The deviation can be either positive or negative. What does this mean for the investor? It simply means that you can't be too lucky for too long. Funnily enough, I can think of many people who have managed to be too unlucky for very long. However, the explanation is actually quite simple - these people chased trends. They got into positive trends without understanding them and inevitably caught the downward part of the cycle when the reversion to mean was imminent.

And how do investors avoid this? Simple, never invest without understanding. This is where Value Research and Wealth Insight come into the picture.