Fundamentals or Funnymentals?

The Indian stock markets crashed in January this year from their highs to a level corresponding to 5000 on the Nifty.
"Buy", said the analysts on the fundamental side. "Stocks have become cheap and India's fundamentals are strong", they said.

The markets crashed further In March to levels corresponding to 4500 on the Nifty.
"Terrific opportunity to buy", said the same guys. "Stocks have become dirt cheap compared to fundamentals. Things would get ok in 6 months time", they argued.

The Nifty rallied to 5300 in a month after that. Some fundamental analysts proclaimed that the bull market had resumed.

The Nifty todays stands close to 4100 levels, more than 20% lower from the highs seen in April/May, and looks like going down further. Supposedly good stocks are down 60-70% from their highs. Some are down even 80-85%.
When would the pain end? Fundamental analysts claim that the pain could last another 12-18 months.

This post is not a criticism of fundamental analysts. It is meant to highlight how no one really understands how the economic scenario would pan out. The subject is far too complex for any one of us to comprehend. Most of us do not have the ability to comprehend and anticipate how the world would look in the future.

A mere 6 months ago, few anticipated how bad the world would look today. Fundamentals of the Indian economy never seemed better in January 2008. Suddenly, they no longer look good. A spate of bad news has hit the world economy and the Indian economy too. Crude oil keeps hitting record highs, inflation is in double digits, interest rates are in the rise, economic growth seems to be slowing down, the country's fiscal situation seems to be detoriating, corporate earnings which were assumed to remain good, now are under threat, across the globe the housing crisis and its fallout does not seem to have played out completely...there is a lot of anxiety and gloom in financial markets. Who had thought we would be in such a position?

Stock prices are supposed to reflect the fundamentals of companies. When we say that stocks have become cheap, there is an underlying assumption that fundamentals are better compared to the decline in stock prices. However if fundamentals detoriate faster than the decline in stock prices, stocks could in fact become more expensive even with a fall in their prices. How do we say how bad fundamentals have become? How do we say how worse they will get? How do we say when would things look better? Since most of us don't understand completely how economic change will happen, we cannot answer such questions.

Fundamentals then are hazy, perhaps we should call them fuzzy-mentals. But it is funny to note how prices move ahead of the news and ahead of fundamentals, that price moves first and then the news follows. Perhaps we should call fundamentals as funny-mentals.

The key thing is to understand the perils of trading/investing on the basis of something we dont understand; and to stick to something we understand. Blind faith in fundamental reasoning is not a smart thing to do. Have blind faith that your mother would always love you. In all other matters, it is wise to keep an open mind.

PS: While the PE ratio may not mean much in isolation, especially for an index whose composition changes across time, here is some data for the PE of the Nifty over the previous lows since 2002. In a ballpark sense, you can establish yourself whether the Nifty (current PE = 17.67) is cheap.

Date --- Nifty PE
25-Oct-02 --- 13.83
17-May-04 --- 12.87
14-Jun-06 --- 14.92
27-Jun-08 --- 17.67