Thursday, March 27, 2014

NIFTY: How Much Fundamental and How Much Expectation

the IMF is out with a new paper which shows the worrying slowdown of fundamentals in Indian economy, especially investment component of GDP.

If you look at the GDP break up it is indeed not very encouraging. But at the same time, the equities in India has seen the best performance by any emerging market. So here is an interesting way to take a deeper look at the recent stock market performance

Markets can either perform based on solid fundamentals, or in a cyclical reactionary manner in response to sentiments and inflows and similar. I model the NIFTY over the years as 


Where F represents the fundamental component and R represents the reactionary component. Then these components are further modelled as below

F = random walk component  + inflation + economic activity (industrial output as proxy). 

The assumption is that the fundamental improvement (or change) will be persistent, more so in case of an emerging market where the economy has much room before reaching technology upper limit of potential. The other component, R is modelled as below

R = auto-regressive component + FII flows + INR + JPY

Here again the intuition is the cyclical component of the index is ideal to be modelled along with short term signals that market will react to, which are themselves cyclical. JPY captures the overall global risk sentiment (a high correlation with NIFTY in recent time).

And here we are with the model estimates - the graph shows the levels of NIFTY over the years split in to these two components

Notice how the fundamental trend (F) lagged the actual levels during the 2000-01 recession and in the exuberance of 07-08, and also notice how the market became to pessimistic after the Lehman failure, trading below fundamental trend. 

Which of course it did catch up. And then some more. Since 2011, the fundamental component has flattened out. Nevertheless NIFTY had a strong rally, totally dominated by the reactionary component

So does that mean now that the market trading way ahead of itself, it is going to correct? Well mostly it is expectation I would say. Will the fundamentals match the expectation already priced in? Anybody's guess. But sooner or later one is going to catch up with the other. I hope it happens in the happy direction!

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