Four ways to predict market performance effectively

Blog | TRADING 101

There is a popular saying among car racers, “You cannot drive with one eye on the rear-view mirror”. That principle applies to trading in the stock markets too. You need to take lessons from past experience but focus on estimating what will happen in the future. As Buffett himself put it, “If the past is all that mattered, then archaeologists would be the wealthiest persons in the world today”. The only way to be able to profit in trading is by estimating the future with a reasonable degree of accuracy. This applies to all asset classes, not just to equities alone. Let us see how to go about predicting the performance of the market in general and stocks in particular.

You are up against supercomputers, so break that matrix

Are you wondering what this means? If you have traded in the markets, you would have surely experienced this. It is estimated that 80-85% of the traders tend to lose money in intraday trading, and that is hardly surprising because you are up against machines that are incredibly fast and can consider a multitude of permutations and combinations which the human mind may take too long. It is not just about algo trading and high frequency trading (HFT). It is also about the use of artificial intelligence and machine learning, where computers are trained to think like humans and act like computers. The only way for you to make money in this kind of a market is to break that matrix. How do you do it? There are 3 ways to break this matrix. Firstly, focus on quality stocks for the long term, where you don’t need to compete with the Deep Blue. Invest in training and skill building as that can get you better results in trading. Lastly, try to estimate value and not the price. After all, price is what you pay, and value is what you get.

Learn from the champs; surely, they know something you don’t

What is this smart money all about? Typically, it is the institutional investors who work at investment banks, mutual funds and hedge funds. Since the smart money is analysing the same data and following the same indicators, a smart money herd mentality is created. The internet allows outsiders to get a glimpse of that mentality—to predict what the smart money is doing and what position it may take on a certain asset. You don’t need to jump in and start buying what institutions are buying. In fact, you shouldn’t do that because their risk appetite and perspective is very different. Instead, you must focus on two important predictors in the market. At a macro level, do a comparison of market cap / GDP of the Indian markets with global markets. Secondly, at a micro level, use price-to-earnings-growth (PEG) ratio to shortlist stocks. The PEG captures undervaluation with reference to growth and hence is extremely authentic and credible in the Indian context.

Start off by taking a macro view first

If you want to form a market view, it is best to begin with a world view or a macro level view. A bottom-up approach really does not work unless you are an institutional investor with corporate access. In the Indian context, there are 3 indicators that are very critical for a macro view. Focus on a combination of the PMI Manufacturing and PMI Services. For a sustained stock market up move, both the indicators must be above 50 with positive momentum. The second indicator is inflation because it influences interest rates and the cost of funds. That directly hits corporate balance sheets and solvency. Lower the inflation, the better it is. Lastly, look at the country’s fiscal deficit. In the Indian context, fiscal deficit within the Fiscal Responsibility and Budget Management (FRBM) limits is always the preferred option. Market upsides at a macro level are more sustainable when the fiscal deficit is within the FRBM limits.

Time to answer 3 key questions

Retail investors should always predict markets on the basis of macros. Of the 3 factors highlighted above, give the highest weightage to high growth and low inflation followed by fiscal deficit. Once you do that, just look at the sectors that could benefit. For example, capital goods benefits from GDP growth, FMCG from consumption led growth, banks from low inflation etc. Finally, focus on the companies with consistent sales and profit growth for the last 5 years. If you do this consistently, you have a greater chance of predicting the market effectively.