Predicting the markets?

What determines stock prices? All of us who pay attention to the fundamentals of companies and their businesses know very well that it's things like profitability, growth, valuations etc. While that's true over periods like years, that's not what determines the numbers on any given day. The numbers on the screen get determined by the balance of supply and demand at the current price. If there's too much demand, the price keeps going up until the two matches. There's nothing more fundamental in microeconomics than this.

Not just that, the stock markets are a perfect laboratory to study this phenomenon. In the real economy, supply-demand and money supply take months or years to shift meaningfully. In the stock markets, it happens within days, hours or even minutes and seconds - price rises, supply increases, transactions happen, price drops, and supply decreases. It's like a speeded-up cartoon version of the broader, real economy. The factors that fundamentally-driven investors swear by are all there at the base, but the shorter-term changes have a different cycle.

So what is it that drives these short-term changes? On any given day, if you switch on a business channel on the TV or look at a news website, you will be told the cause - some recent statistic or event. It could be GDP, oil prices, interest rates, a political event, something, anything. Actually, most of the time, the reason and the logic for these changes are not known and, in fact, unknowable. The reasons you get to know in the media and social media are generally invented post-facto.

Those who invest in stocks have another information-analysis problem that's bigger. How do you predict - or even just detect - whether the markets are at a high or at a low? In other words, is the direction going to change? A number of heuristics or rules of thumb are promoted as indicators of whether markets are so high that they must start falling soon or whether they are so low that they must start rising.

For example, a market top is supposedly characterised by lots of high-priced IPOs, record high valuations, widespread coverage of equity in non-business media, a large influx of new investors into equities, high volumes on the equity markets and other similar signs. On the other hand, a market low is said to be characterised by pretty much the opposite of all these. IPOs dry up, valuations are low, trading is low, people who started investing recently run away from the markets and stop talking about investing on social media, corporate deals dry up, and so on.

Do you think watching these signs works? By 'works', I mean that you can watch out for signs and detect whether the markets are about to change direction. It turns out that you really can't. Just like the daily reasons trotted out by TV anchors, these are also retrospective explanations rather than prospective indicators. One of the reasons is that there are always exceptions. Some signs will point one way and some the other. Even within individual factors, there will be variations. Many companies will have high valuations, but some will be low. The IPO scene will be almost dead, but a handful will do well. Investors can look at the signs and console themselves about what is happening but cannot use these things to take decisions. In other words, all this is basically just time-pass.

The right thing to do is to never buy according to where you (or others) believe the market is heading. Investors need to invest according to the quality of an investment, and whether it is fairly priced according to its intrinsic characteristics, and not by guessing its future momentum. As more than a century of experience has shown, timing markets is no better than acting randomly. For mutual fund investors, it is even easier. They should choose three or four equity funds with good long-term track records, invest steadily through SIPs, and not bother with market crashes. The whole point of investing in a mutual fund, either through a SIP or otherwise, is to continue doing so in bad times.

Smart investors don't try to predict where the markets are headed. Instead, they find a way to invest in which making correct predictions does not matter.

Suggested read: A perfect prediction