Comparing 5 Investing Strategies

"Don't try to time the markets".
"SIP is the best way an average investor can participate in the stock markets."
"Asset Allocation is critical. Allocate your assets across stocks and bonds according to your risk profile".
"Hold stocks for the long run".

The professional investment community loves to push such advise to the average investor. Investors, in turn, fall in line and play along thinking that the advisors are experts and hence know best. Such statements become gospels and people follow them blindly.

Do such statements really hold weight? An examination is worth the time spent.

But first, let us figure out what constitutes a good investment.

The most obvious thing is return on investment. Everyone wants this to be as high as possible. Thats a no-brainer.

However returns are not risk free. An investment that offers higher return than another one with the same amount of risk is a better investment (all other things being equal). We like to make a lot of money with the least risk possible (unless one seeks thrill out of risk taking). Hence risk is another parameter of an investment.

Returns can be stable or returns can be volatile. When returns are volatile, we experience large swings in our equity. While we love it when we get large upswings, large downswings cause large depletions in our equity, they cause anguish and anxiety. Normal people would, given all other things being equal, rather not have such large downswings. Hence a downswing (peak to trough move called a drawdown) is another parameter we should measure.

Some people might seek high returns and be willing to tolerate high drawdowns. Others may be happy with lower returns but a lower drawdown. It depends upon the investor. To equalise drawdowns, we compare it with the return and arrive at a ratio (lets call is the Stress Ratio) as drawdown per unit return. i.e Drawdown/Return.

The lower the Stress Ratio, the lesser is the drawdown compared to the return, hence the lesser the stress caused to the investor.

(I have not considered standard measures such as te Sharpe Ratio, Treynor Ratio etc since they are period dependant for calculating the standard deviations)

With this little background, let us compare 5 different investing strategies.

All of them have been back tested on the S&P CNX Nifty from July 1990 (max data available) till July 2008, i.e. 18 years. Each assumes a transaction cost of 0.6% mainly as brokerage. The strategies are as follows:

1.) Buy and Hold:
You bought the Nifty in July 1991 and held on without any activity over the entire duration. Stay invested for the long run.

2.) Asset Allocation based on Price:
You split your money in the ratio 70:30 between the Nifty and 1 month Fixed Deposit and rebalanced your portfolio every month to maintain this 70:30 ratio. So if stocks went up and the ratio of stocks in your portfolio exceeded 70%, you sold some stocks and put the proceeds into a 1 month fixed deposit so as the restore the ratio to 70:30. When stocks fell, you did the reverse. Automatically, you bought stocks low and sold them high...seems nice, doesnt it?

3.) Asset Allocation based on valuation:
You use the Price to Earnings ratio (PE) of the index to decide your equity and debt allocation. You set a percentage for equity (100% in equity if PE <=15 linearly decreasing to 50% for PE = 25 and then linearly decreasing faster till equity = 0% for PE>=30) depending upon whether the index is cheap or expensive. Automatically, you bought stocks when they were cheap and sold them when they got expensive...again, seems very sensible.

4.) Cost Averaging or SIP
You invested a fixed sum of money into the markets through the Nifty first trading day of every month, month after month. You bought more units when markets were down and bought lesser units when markets were up. Some kind of cost averaging here. This is what advisors propound. Of course, mutual fund houses love this (they get a regular and assured stream of money coming into their schemes).

5.) Market Timing using Trend Following:
While no one knows market tops and bottoms, here you buy the Nifty after market bottoms have been established and markets start moving up and sell after market tops have been established and markets start moving down. One such strategy is used. This strategy means you wait for a bottom to form and once you identify a bottom, you buy. Similarly for selling, you sell once prices start to fall. We follow certain rules for buying and selling. Essentially you (imperfectly) time the markets.

So how do these strategies compare? Given below is a table depicting their performance:

(Theoritically, price can go down to zero. Hence in the first 4 strategies, risk is equal to the equity exposure)

Clearly, Trend Following (a kind of market timing) gives you the best return with the least risk and the least maximum drawdown. Also, the Stress ratio is lowest at less than 1.
The difference between market timing and other popular strategies is striking. Market timing gives a higher return at lower risk with lesser stress. Note the difference in the ending amounts for Rs. 1 lakh invested (last column).

PE based Asset Allocation also gives a better performance compared to the other three. Buy and Hold strategy gives a higher return than an SIP or price based asset allocation, but has the largest drawdown.

Note how an SIP is the worst in terms of returns and also in terms of the Stress ratio. So much for the merits of an SIP!!

Another observation not reflected in the table is that trend following gives much lower drawdowns compared to the other 4 methods. Also, drawdowns are recovered faster with trend following.

Ok, you may say. The 1990s had long periods of bad market performance. How about the performance in the bull market that started in April 2003? Here is the same till date:

A raging bull market makes buy and hold the best approach but with a large drawdown. So is the case with PE based asset allocation which has shown a better drawdown and hence a better Stress Ratio. Trend following has a lower return but a better drawdown performance and a superior stress ratio. Again, SIP is poorest in terms of return performance as in terms of stress ratio.

Note however that if you remove the period from April 2003 till date, the performance of the first 4 strategies turns out pretty bad. The returns for July 1990 till March 2003 for the first 4 strategies come in at 9-11%, while that for Trend Following comes in at 20.1%. Trend following is more consistant in good and bad times.

Perhaps we can draw some conclusions from the above analysis:
-We compared 5 rule based investing non-discretionary methods.
-Market timing can work. In fact, over long periods, the performance of one such method (trend following) seems markedly superior to the other popular methods.
-Popular methods like buy-and-hold, Asset Allocation and SIP do not have risk control mechanisms. Prices can go down and keep going down and cause a great deal of anxiety.
-SIP and Asset Allocation stategies are defensive in nature. They prevent greater losses than what would have occured otherwise. They do not make you more money.
-Market timing creates more wealth with less risk and lower stress. We should attempt market timing of some kind instead of avoiding it.

The big guys got it wrong!

Even the big guys got the markets wrong. The Mint has reported this in it's 4th July edition. Here are some excerpts of the same. After the first fall in the stock markets in mid January this year, most brokerages recommended that investor should buy stocks as the worst was over. Clearly, the worst was not over!! The markets have continued to fall since then.


Macquaire Research on 23 Jan 2008:
Correction provides an opportunity.
- The worst is over and we maintain our bullish stance.
- RBI will cut interest rates by 25 basis points and accelerate the fall in interest rates
- Top picks: ICICI Bank, HDFC Bank, Axis Bank, DLF Ltd.
- Fundamentals remain strong
- Underlying India story remains strong and this correction remains an ideal opportunity to enter for the long term.

Deutsche Bank on 23 Jan 2008:
Long term investors should increase their India exposure
-Surprised by the ferocity of the fall
-Long term investors should increase their India exposure
-Focus on large cap domestic plays
-Overweight: autos, private banks, capital goods, cement and media
-Underweight: IT, metals, oil and gas/petrochemicals, pharmaceuticals

CLSA on 21 Jan 2008:
India growth story not at risk
-The Indian growth story, led by an upsurge in investments and domestic consumption, remains largely intact.
-The government is likely to keep liquidity strong
-Remain buyers of our 2008 conviction picks—Bharti Airtel Ltd, Bharat Heavy Electricals Ltd, ICICI Bank Ltd, ITC Ltd and Tata Power Co. Ltd

Lehman Brothers on 23 January 2008
We expect 33% return from the market over 12 months
-The recent 20% correction in the market has brought valuations to reasonable levels
-This is not an unreasonably expensive (market) in view of growth and its relative insulation from global credit problems and the US slowdown
-The fall presents a good buying opportunity across several sectors and stocks
-The Indian market is now attractively priced
-From the current levels, the market should see a broad-based rally

Credit Suisse on 23 January 2008
Not the time to sell, even with a dire world view
-For a value investor that does not have positive views on external flows, only a Sensex fall below 13,000 would represent an entry point justified from a valuation viewpoint.
-That said, this is not the time to sell, even for those with dire views on the world economy.
-India is likely to be on a highly reflationary policy drive in the coming weeks unlike most others in the emerging world.
-The market fall has raised the chances of both interest and tax rates cut by February end
-As risk aversion rises and we see more earnings downgrades, this could easily come down to around 13,000

Morgan Stanley on 25 January 2008
Keep a close watch on earnings
-The fact that earnings appear to be well above trend, slowing macro growth due to high real rates, and the dependence on margins to sustain earnings growth given that topline growth is harder to come by
-Earnings a bit more vulnerable than at any point over the preceding four years
-Base of upward revisions is likely to be tested in the coming weeks and the growth itself could be in the low-to mid-teens

Sharekhan Ltd on 23 January 2008
A strong opportunity to buy
-Several of our stock ideas have corrected significantly and are currently available at very attractive valuations
-We view this correction as a strong opportunity to buy

ICICI Securities Ltd on 23 January 2008
The pain seems to be completely behind us
-We firmly believe that the sharp declines in stock prices are not a reflection of any significant adverse impact on fundamentals and provide a very attractive opportunity to buy
-We reiterate our Sensex target of 25,500 by December 2008


Even the large guys with their battery of analysts and experts and years of experience get the economy and markets wrong. The dominant thinking in January was that fundamentals were strong, earnings would continue to be robust and interest rates were headed down. This world view has now been turned upside down.

For most parts, the world looks nice and comfortable and keeps chugging along smoothly with few hiccups. Then one day, without notice, it gets slammed with disaster. Many days of comfort lulls us into believing that things will remain good forever. Investing seems like a walk in the park and making money from markets seems like the easiest job in the world...untill the storm sneaks upon us and destroys a lot of wealth created in the good years. As the legendary investor, Warren Buffet, said, "Speculation is most dangerous when it looks easiest". So if you have made some easy money, you should stop and think whether it is time for the tide to turn.

Things beyond our understanding do go wrong, often terribly wrong. Investors should accept the possibility of such events (they keep happening on and off) and be prepared to protect themselves when they happen. Otherwise they would be left with 40-70% or even more of their wealth destroyed, as has happened this time around.

Why? Wrong causation

"The markets crashed on rising crude oil prices."

"Banking, Realty stocks hit on high inflation data."

"Markets bounce back on the back of prospects that the UPA government will survive its full term".

You would have heard or read such comments quite frequently on business channels and in newspapers. The media tries to explain every market move. It tries to find reasons for changes in price. So if stocks go down and crude oil prices also have also risen, they simply put together a causation: Rise in crude prices caused stock prices to fall.

(These days there is a popular view that stock are falling primarily because crude oil prices are so high. Absent the rise and stocks would rise, is the implicit logic. I think this is just an excuse.)

I have often noticed how this explanation is far removed from what happens on floor of the stock markets. Sometime ago, on a particular friday, inflation figures came our slightly higher than expectations, but not too divergent from the expected figure. The markets promptly went up with the Nifty gaining 20 points. The markets stayed high for a few more hours but eventually collapsed at the end of the day to close in the negative. The newspaper headlines next day screamed how markets were spooked by high inflation.

The truth was that markets actually went up after the news and stayed there for quite some time. Clearly, the inflation figure did not cause markets to fall. What caused them to collapse? - we don't know for sure. All we know is that the prices went up when inflation figures were released and they went down at the end of the trading day.

According to the media, a $2 rise in crude oil prices caused stock markets to go down on a particular day. However, on another day, a $5 rise in crude oil prices saw the stock markets going up without any other positive news. So why did a greater rise in oil prices not cause markets to go down with even greater force? We don't know!

Media will keep searching for reasons behind price movements. It simply draws cause and effect relationships with an external event and market moves. However this might just be a convinient excuse to explain market phenomenon. As we have seen, the same external event causes diametrically opposite moves in the markets, across time. Sometimes markets fall after bad news. Sometimes markets rise after receiving the same bad news. The fact is that we really do not know why markets move on any given day. The only thing we can say is that if selling is greater than buying, prices fall. If buying is more than selling, prices rise. That is the most obvious thing there is, but in reality that is all that we know about price movements.

So the headlines should be like:

"Markets went down as selling exceeded buying. Reasons unknown!"

I doubt we would ever see such a headline. For us, what matters however is whether prices are up or down. True reasons perhaps we shall never know...and don't even need to know.

Why losses should be kept small - A mathematical view

"Cut your losses short and let your profits run."

I keep repeating this cliche ad nauseum. Seasoned traders swear by it. Amateurs flout it (to their own detriment). I believe it is key to investment success. Intuitively we might agree that it is important, but can we really prove it's worth?

Investors seek returns from their investments and trading decisions. Amateur investors like to make money on every trade/investment. While we might want our investments to be winners, there are too many imponderables that could put a spanner in their wheels. Ergo, we can land up with losses as well (whether or not we book them). In the markets all outcomes are uncertain. Profits and losses, both, are part of the trading landscape. (In fact, successful speculators lose more often than they win)

Since every outcome is uncertain, winning merely has probability, as has losing. So over time, we would have some winning investments and some losing investments. Lets consider the following:

W = Probability of Winning (0<=W<=1)

L = Probability of Losing (0<=L<=1, L=1-W assuming no breakeven trade)

AP = Average size of profits (AP>0)

AL = Average size of losses (AL<0)

This brings us the what is termed as the Mathematical Expectation (E) of our investing decisions. E is the Expected Profit per trade.

E = W*AP + L*AL

(Note that the product L*AL is negative since AL has a negative value.)

E denotes what profit we will make on an average per trade. All other things being equal, the larger the value of E, the better it is for our returns. Traders should strive to achieve a high value for E from their trades.

Look at the right hand side of the above equation. For E to be high, the first part (W*AP) of the sum needs to be high while the second part (L*AL) needs to be kept to a small (negative) value.

For W*AP to be high, either W needs to be high or AP needs to be high or both.

But W has an upper limit and cannot get higher than 1. (1 implies all winning investments)

AP in contrast does not have any upper bound. Though profits don't go to the moon, large profits are not uncommon.

Just to illustrate, say,

AP = 4% and W = 0.8 (80% chance of success), W*AP = 3.2%

AP = 8% and W = 0.6 (60% chance of success), W*AP = 4.8%

AP = 16% and W = 0.4 (40% chance of success), W*AP = 6.4%

AP = 50% and W = 0.2 (20% chance of success), W*AP = 25%

Your profits go up even as your winning percentage goes down. It is easier to find investments with a lower success rate. Most people want to maximise the chance of winning. Professionals focus on maximising profit instead, not the chance of winning. If risk is properly managed (which it should be), it is much easier to find trades that have a lower chance of making money than ones that have 80%, 90% or higher chance of success.

In the product, W*AP, it is AP that plays a much dominant role compared to W in determining the product. Average Profit is more important than the Winning Percentage. Try seeking a high value for average profits - LET YOUR PROFITS RUN

Using the same logic, on the other part of the equation, L*AL, average losses are more important than chance of loss. For example,

L= 2% and L= 0.6 (40% chance of success), L*AL= 1.2%

L= 5% and L= 0.5 (50% chance of success), L*AL= 2.5%

L= 10% and L= 0.4 (60% chance of success), L*AL= 4%

L= 20% and L= 0.3 (70% chance of success), L*AL= 6%

The chance of success is increasing, but your losses are also going up.

An 5 fold increase in average loss needs to be compensated by a 80% decrease in your losing percentage. If average loss increases from 2% to 10%, your winning percentage (initial value = 50% = chance of heads on a coin flip) needs to increase to 90%, not an easy task. It is much easier to keep a loss down to 2% and get a 50% success rate than to let losses increase to 10% in an attempt to get a 90% success rate.

The bottomline is: Keep average losses small - CUT LOSSES SHORT

Let profits run and cut your losses short! When you have a profit, don't sell under the fear that the markets would take away your profits. Let profits become big. When you have a loss, don't hope that it would turn around. Don't let losses get big.

It does not matter whether you win or lose. What matters is how much money you make when you win and how much money you lose when you don't win.

After the Stock Market, is Real Estate next?

After the collapse of the Indian stock market, is real estate next in line for a fall?

Some people say yes, others vehemently deny such a possibility. Let us try to analyse the situation in residential real estate. Now, any analysis of an asset market is always based on given information and logical, validated assumptions. Our information could be incomplete and our logical constructs limited by the unknown. Hence our conclusions could be wrong. But that does not stop us from analysing.

But before all, let us recall that real estate is local. So it is possible that prices fall in one part of the country but are rising in other parts. Our analysis would be general in nature.

There is a community of people who believe that the price of Indian real estate does not go down. They agree that prices in developed markets such as USA, UK, etc can and do go down, but not in India. I think that is a dangerous belief.

The price of any asset is governed by the laws of demand and supply, real estate included. When quantity demanded outstrips quantity supplied, prices rise. When quantity supplied is greater, prices fall. That is what happens in a free market. Empirically evidence suggests the same. There was a real estate boom in the mid 1990's in India. If one would recall, it did not end too well. Prices did come off 40% in some areas in Delhi and 35-40% even in land starved Mumbai.

Detractors agree, but contend that the real estate market, at least the residential market, is not a free market. Large developers 'hold' prices artificially even if demand slackens relative to supply. When demand rises again, they are able to sell at high prices. Hence prices don't fall. We shall look at this argument later in this post.

But first, let us get a sense of the actual demand for housing in our country. It is estimated that there is a demand of 2 crore homes in India. That seems like a big number, big enough to sustain any boom in residential real estate. Some of this would be for apartments, some for bunglows, etc. For the sake of ease in calculations, let us assume that this is to be met by multi-story apartments. Most of the demand would be from middle to low income group. Assume a liberal average area of 1200 sq feet per apartment. This translates into an area of 2400 crore square feet of construction. Seems huge! Again, assume and an average of 10 floors per building. Thus the total construction area required will be 2400/10 = 240 crore sq feet of land.

Assume that as per the norm being followed, 30% of land is used for construction while 70% is left open. So the land required for housing would be 240/0.3 = 800 crore sq ft.

If this looks like a mind-boggling number, think again. One sq kilometer has 1.0763 crore sq feet. So 800 crore sq feet land is about 744 sq. km of land. To meet the housing needs of the entire country, we need 744 sq km of land!

Delhi has an area of 1483 sq km.(Source:Wikipedia). Thus the entire housing need of the country can be met within half of Delhi's land area!! That is all the land required! India is not Japan where land is short. The total land area in India is approximately 32.88 lakh sq km. India can satisfy the housing needs of its population in 0.02% of its land!!

Is buying a house affordable now? It depends upon which city/area you are talking about. In general however, one measure of whether buying a house is affordable is to look at whether the current owner-residents can buy their own house. Anecdotal evidence suggests that such cases are few and between and in many areas prices are way beyond the reach of current owners. At least I can vouch for the area I stay in, and in the area my parents stay (different city). In such scenarios, only fresh demand from richer/high income people can cause prices to rise further. True, incomes have risen over the last 4-5 years. But so have expenses, fresh expense heads do come up and housing prices have risen faster than rise in incomes. Prices in many areas quote at crazy levels. Make no mistake, India needs property, lots of it. But at much lower prices.

What about buying on borrowed money? For borrowers, a rising interest rate regime is a bad sign. Rising interest rates make EMI payments go up, buying a house, especially at elevated prices becomes unaffordable and buyers refrain. Prices do not go up when demand slumps. Interest rates are rising and threatening to go higher, which is not good news for demand.

And then there is the supply side. A capitalistic economy follows a typical boom-bust cycle, called the business cycle. Demand rises compared to supply. Since additional supply usually takes time to come through, rising demand causes prices to rise. Rising prices increase the profitablity of existing suppliers. The lure of easy money entices more suppliers to enter the industry, each hoping to make supernormal profits. At the same time, rising prices curbs demand. As more suppliers enter the industry, at some point, supply exceeds demand, inventories pile up, prices eventually fall to levels where the market clears and demand and supply are in equilibrium. It happens all the time!

And that is almost sure to happen. Take an example of Gurgaon, Haryana. The existing supply of ready-to-live apartments is about 8000-9000 units. Prices have risen over the last few years in Gurgaon on the back of higher demand over existing supply. Higher prices have lured developers to increase supply. Over the next 3-4 years, a projected 20000-25000 (my conservative count) new apartments will come in the market. This is over 2-3 times the current supply. Sure, some demand will exist, but will it be enough to take care of such a supply - I am not sure of that!

Developers have a vested interest in being bullish about real estate prices. Some developers claim that demand is robust. Others reluctantly admit that while demand has gone down, prices have not. I can't understand how a fall in demand cannot not lead to a fall in prices. Unless the developers themselves are 'holding' prices and not allowing them to collapse. Maybe they can do so in the short run. Some are deep pocketed and might be willing to sustain losses for a while. But many others are facing a serious cash crunch. And there is a limit to which prices can be artificially supported, if such is the case. There are reports that many developers have borrowed money from the market at high interest rates. If new housing does not sell, how will profits look like? The stock markets are anticipating trouble for housing companies. Have a look at the table below to see the serious damage in the share prices of prominant developers (30 June 08):

Stock.....%Fall from highs
DLF.....68%
Unitech....69%
Parsvnath....80%
Ansal....86%
Omaxe....79%
HDIL....73%
Sobha....74%

The previous boom (mid 1990's) in real estate in India started to go bust on the back of rising interest rates in 1994-95 and on oversupply. The impact was felt with a lag. The current boom is now facing headwinds on interest rates, not dis-similar to the one felt back then. Will there be a bust again? It seems possible though no one can be sure. Maybe prices will fall. Maybe there would be a time-wise correction with prices going nowhere for extended periods. I dont know for sure what would happen. But looking at the scenario the risks to housing seems to be on the downside.

Do SIPs really work?

A Systematic Investment Plan (SIP) is an investment plan that allocates a fixed sum of money (usually the same amount) at a regular frequency (month/quarter/etc) to an asset class (like stocks/bonds/gold/etc). For example, every month you invest, say, Rs. 25000 in a mutual fund and keep doing this month after month.

SIP is an idea that the professional investment community loves to push. Every day we read so called experts advising people to go in for SIPs. Mutual funds come out with advertisements urging investors to buy a SIP in their companies. It is common wisdom that SIP is a good way to make money over the long term.

SIPs look like a great idea. It is convinient and affordable for the average investor. All you have to do is to simply put away a small sum into the markets - the same amount every month. When prices are low, you get a higher number of shares or mutual fund units. When prices are high, you get a smaller number of shares/units. A classic case of rupee cost averaging, which essentially is the foundation of a SIP! It seems like a great way to take market exposure and a great way to make money.

There is just one little thing. It doesn't work!!

Have a look at empirical evidence. If you had invested Rs. 10000 in the BSE Sensex on the first trading day of every month from January 1992 till April 2003 (more than 11 years) your total investment of Rs. 13.6 lakhs would have become 12.33 lakhs giving you a -1.8% return compounded annually over the period. You would have actually lost money. Compare this with a one-time investment in the Sensex in January 1992, which would have given you a 4% (positive) annual return. Add transaction costs and the performance of the SIP would look worse.

How about the period in the current bull run? From May 2003 till date (27 June 2008), the Sensex has gone up at the rate of 34.6% compounded annually. In contrast, the same SIP would have invested Rs. 6.2 lakhs and would have made Rs. 11.17 lakhs at an annual compounded growth rate of 23.7%. Not bad, but still lower than the return on a lump sum investment!

One instance where rupee cost averaging (and hence a SIP) can work in the long run is, if for the first 7-8 years prices keep falling and take off steeply in the latter part of the investing period.

Rupee cost averaging - like diversification- does not make you more money. It prevents you from losing more money in certain market conditions (like a falling market) than you would have lost otherwise. If that's good enough for you, fine. But if you are convinced that a market or asset will go up over time, rupee cost averaging does not make sense. In short, if you like an investment, simply go for it.

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