Identifying market direction holds the key to making informed investment decisions

“Maang-Poorti, Vyaapaar Chakra Evam Ausat-Punaravriti Ye Teen Hain Niyam Mahaan Baazaar Ke Dishaa- Nirdhaarak Hain, Nivesh -Nirnay Ke Pahle Kar Lo Pahchaan”

Translation: Demand-supply, business cycle and mean reversion, these three rules are grand. They guide the market courses; identify them before taking an investment stand.

In the intricate world of economics and investments, successful decision-making requires a keen understanding of various factors that shape market dynamics. Towards this, the three fundamental rules include demand-supply; business cycle and mean reversion. They stand out as crucial indicators for identifying market direction and making informed investment decisions.

At the heart of any thriving market is the principle of demand and supply. For instance, in the physical world of goods and services, it dictates the pricing power of the businesses and the willingness to create capacity. A business will only be desirous to invest and grow when it sees a certain level of demand. A lack of demand can cause an industry to die. A clear case example is the shift from print media to digital media, shift from basic phones to smart phones leading the leading mobile company Nokia to shut down its business in Chennai. Failure to adapt to changing demand patterns can cause a bleed to business profitability.

In the financial world, the interplay of interest rates and corporate profits along with existing price of share market drives the demand preference of equities, debt or gold (aka other commodities). Understanding consumer behavior and market trends is essential for predicting which businesses or asset class is likely to excel in this regard.

Economies are cyclical, and understanding these cycles is the key to making strategic investment decisions. The business cycle encompasses the fluctuations in economic activity, characterized by periods of expansion, peak, contraction, and trough.

For instance, during an economic expansion, cyclical industries like capital goods, financials, industrials, building materials tend to thrive, while sectors like healthcare and utilities may perform better during a contraction.

Similarly, gyrations in financial markets have greatly influenced real activity around the world over the past two decades. The Japanese housing market crash of early 1990s, Asian financial crisis in late 90s, and the 2008 great financial crisis are clear examples that booms are almost always followed by a bust. Though, there could be a long and variable lag to the duration of these cycles. A very recent example is that the monetary and fiscal excesses by the US post-Covid, which led to sky rocketing commodities and equity prices, are now gradually getting corrected once these excesses are being reined in.

Different industries and asset classes perform differently at various stages of the cycle. Recognizing the current position in the business cycle allows investors to allocate their assets effectively. Understanding the interest rate and business cycle is at the core of asset allocation for any astute fund manager.

The principle of mean reversion emphasizes the historical patterns and trends that tend to repeat themselves over time. Investors who study past market behaviors gain valuable insights into potential future movements. Analyzing averages, such as stock prices, economic indicators, and performance metrics, helps identify patterns that can guide investment decisions. However, it's crucial to supplement historical analysis with a forward-looking approach, considering evolving market conditions and external factors. It is often said that History does not repeat but rhymes.

And today, we are at such a juncture in global economy and geopolitics that understanding economic and financial history is of paramount importance. Inflation has returned to the US after nearly two decades. Monetary policy is reacting in a way not seen in the last three decades. Many of us would not even be born or would be too small to have a vivid memory of the situation. An unconventional peace fettered international politics post the demise of the Great wall of Berlin in 1991. It saw signs of defection since 2017 when Trump began to challenge China’s rising dominance. Today geopolitics has risen once again, and investors are dusting their old books on markets during Cold War.

Learning from the past is a cornerstone of becoming a successful fund manager. By studying historical market data, fund managers can develop a keen sense of pattern recognition. Recognizing recurring trends, cycles, and anomalies enables them to make more informed predictions about future market movements.

In the dynamic realm of investments, mastering the interplay between Demand-Supply, Business Cycle and Mean Reversion is a powerful strategy. Investors who diligently apply these principles are better equipped to navigate market uncertainties, identify opportunities, and make sound decisions that align with the prevailing economic conditions. As the market direction becomes clearer through the lens of these three rules, investors can position themselves strategically for long-term success in an ever-evolving economic landscape.

Most times, an individual investor may lack the right acumen or time commitment to understand the nitty-gritties of markets. Mutual funds are the right choice then where portfolio managers invest considerable time and effort to master the fundamentals of the market, invest and churn the money accordingly. Fund managers operate within an institutional framework which enforces certain ground rules of investing, keeping in mind the best interests of investors.

(The writer is senior vice-president, SBI Funds Management Ltd; Translation is by Namrata Mittal, AVP & Chief Economist, SBI Funds Management Ltd)