Chart Fun | Mind Of The Market
Pavlov presented dogs with a ringing bell followed by food. The food elicited salivation, and after repeated bell-food pairings the bell also caused the dogs to salivate. Over time, the dogs began salivating upon seeing the white coat of lab assistants. Pavlov found that after repeated association, the dogs would respond to stimuli other than food.
Ivan Pavlov would’ve probably found more interesting subjects had he peered into the largest laboratory of human psychology in the world: financial markets. Where frigid numbers and emotive participants spar enthusiastically in a perennial drama-in-motion. Where participants interact with the crowd, internalizing the herd’s behavior at a subconscious level. With time, the behavioral response and narratives become Pavlovian in nature.
Financial history is a rich repository offering several interesting instances of Pavlovian Conditioning.
This edition peers through the lens of history to look at interesting examples of how prices drive narratives; and then how narratives drive prices, in Pavlovian fashion.
Mind Of The Market I: Amazon
The first example travels back to the Dot-com bubble, and depicts market imputed expectations from Amazon in early 2000. At the peak of the bubble, soaring prices of internet companies fueled market expectations; which soon divorced from reality. The new age was upon humankind. Amazon was at the vanguard of this movement.
Expectations embedded in prices exceeded subsequent Reality by a wide margin in 2000. Within the next 2 years, Amazon stock sold off by 90% in the aftermath of the Dot-com bubble.
What happened to the stock price over subsequent 5 year periods?
In 2000, markets expected Amazon to churn out nearly $14 billion in free cash flow over the next decade.
In 2001, this expectation morphed into a cumulative cash burn of nearly $4 billion!
The company remained the same (AWS and Prime were far in the future). Yet, what the markets expected from Amazon had changed dramatically.
From 8x Price/Revenue in 2000, Amazon valuation dropped to 0.7x Price/Revenue within 2 years!
Mind Of The Market II: Nestle India
The next example from history is an Indian market darling.
We travel to 2001 to glimpse what the markets expected from Nestle India.
Reality exceeded market expectations over the next 10 years. The stock price reflected this, compounding at 20% over the next 5 years.
Cut to today.
What do prices say about market expectations from Nestle India?
Back in 2001, Nestle India traded at a 2.7x Price/Revenue multiple. The forecast revenue growth rate was rather modest; so were profitability expectations.
The present day paints a vastly different picture.
Markets expect Nestle India to grow at 1.7x its peak historical 10-year Revenue growth rate.
And; deliver this on record profitability.
Now, both may well happen (‘prediction is very difficult, especially about the future’). In which case, the stock — despite seemingly priced to perfection — may deliver an attractive return to equity investors. The balance of odds, though, seem tilted in favor of expectations exceeding potential operating reality.
Markets demonstrate a talent for clothing extreme expectations in the attractive attire of an acceptable narrative.
But…
The retorts are aloud. “Great company, great management, TINA effect (There Is No Alternative)”.
All true.
But what do such imputed expectations say about us (market participants)?
A long holding period can sometimes compensate for a high purchase price.
How truly long is the average holding period for most investors?
Nestle India’s strong operating performance over the past two decades has nudged market participants to expect an outlier operating performance over the coming decade.
Pavlovian Conditioning.
Mind Of The Market III: Tale Of Two Decades
We turn our attentions to the past two decades in Indian Equity markets.
Price performance ranges are grouped by decades for: a) ‘Junk’ and b) ‘Quality’.
2000s Pavlovian Narrative
‘Junk’ had a stellar run in the 2000s decade; thanks to the China boom. India was shining. The markets expected, and bet on, an infrastructure and lending boom. Growth was bid, and quality took a backseat. Some of the most well-known quality names of the 2010s decade (Hindustan Unilever) had a quiet decade. Markets overwhelmingly favored ‘junk’ pockets (of course, they weren’t thought of as ‘junk’ at the time!). Technology had an outright forgettable decade.
2010s Pavlovian Narrative
Lehman crisis changed the narrative. Slowing economic growth put the spotlight on borrower capacity to repay past debts. Banks came under the scanner — particularly the public sector banks — and investor interest waned considerably towards ‘junk’. Most of the ‘junk’ universe had a lost 2010s decade. ‘Quality’ picked up the baton, as investors piled in. Erstwhile laggards were rediscovered, as the catch up trade swung into action. Larger companies fared generally better than smaller ones.
2020s Decade: Which narrative can go Pavlovian?
Two broad narratives are taking shape in a tug of war for supremacy.
Quality Forever
- India’s tryst with $5 trillion is inevitable. The Indian consumer will lead this gallop. Supply of capital to this pocket has ballooned, growth slowdown notwithstanding. Anything with a ‘retail’ thrown in has been a re-rating candidate. Private capital spending has been on the wane. Buy anyone that caters to the Indian Consumer.
- Repeated offenses by previous ‘AAA’ companies (IL&FS, DHFL) and banking system woes mean that the only game in town is the Quality universe. The probability of capital loss is the lowest in this universe. Consequently, they warrant a lion’s share of attention and capital.
Capex Recovery
- India’s tryst with $5 trillion is inevitable. Private capital spending will have to fire for this to be achieved. The Indian consumer is over-serviced. The latter half of the 2010s decade — with GST, demonetization, adjustment, system clean-up — has taken a toll on the non-consumer pockets. Stock prices reflect these to a large extent. A capital spending recovery is inevitable.
- Consumer oriented pockets are priced to perfection. Once (1) starts showing up, a catch-up in earnings growth — which has been subdued — in spending oriented pockets is inevitable. This universe will then experience strong price catch-up. Buy the fast growers/ignored pockets.
What do you think?
Psychology of herding
We squint at the future through the foggy glass of the present. Stretching the timeline increases fogginess. Most investors are in the business of placing short-term bets on long-term outcomes.
When we struggle to see what can transpire at the distance (in terms of timescales), we prefer to glance at the immediate as a guiding light for our own behavior.
Market participants tend to imbibe the crowd’s thinking, often subconsciously. This permeates across the market participant landscape. Investment managers prefer to play it safe (‘hey, you can’t get fired for buying Nestle!’). An agreeable security selection/theme tends to be a magnet for capital flows. FOMO pushes investors to seek a home in pockets that have exhibited strong price behavior.
High behavioral switching costs tend to create opportunities in ignored pockets of the market landscape. But the adoption cycle takes time for this to assume a cult persona.
Which Pavlovian narrative will assume cult persona?
