Follow the Cycles, not the Narrative!

“Herd follows the narrative whereas Contrarian follows the Cycles”

Let us start with some interesting facts and then turn to intriguing questions…

Last few weeks have witnessed some dramatic changes in prices in certain asset classes. Oil prices are up by 25 to 30%, IT stocks in India came out of slumber and produced stunning returns, Indian Gsec ten year bonds crashed and globally dollar index is down by over 10%+ etc. Behind these seemingly disconnected events, is there a common thread that is running across?

To explore this, let us turn to the questions.

Why does a 1 to 2% change in forecast for oil demand results in 30%+ change in crude oil price? How does a marginal change in forecast for IT spending galvanizes IT stock prices into frenzy? It doesn’t stop here. Mere 3% change in Govt. borrowing has busted the bond prices by over 15% or marginal change in relative monetary policy stance had an outsized impact on the global currency markets with dollar index diving by over 10%.

What is going on here?

“Market is a huge magnifying machine. Direction, not the magnitude sets up the asset prices in this asymmetric world where frothy financial flows distort everything deviously”

It is the nature of markets to mis-price assets for marginal changes in fundamentals. Changes in fundamentals are not anything rare, constantly occurring, driven by dynamics of business cycles. Much of the times, in such changes in business cycles, mis-pricing gets magnified because of the distortion of flows that gets dictated by amplified narratives that accompanies such cyclical, but marginal changes in magnitude.

One will be able to appreciate this phenomenon more thro’ an illustration. Closer look at the dynamics of IT stocks in various downturns over last several years will offer clues to the phenomenon we are talking about.

As someone wise said, Tech spending that drives stocks prices in IT sector is after-all cyclical and it moves in line with global GDP growth prospects in general and with US growth prospects in particular. That said, it is not that simple. What adds complexity is the variable lag time between GDP growth and IT spending. Lag time has been different in each of the past downturns in IT spending. Where it turns interesting is, every time when tech spending hits cyclical low in the past, narrative turned manically negative amplifying some of the ongoing challenges the Industry faces from time to time.

“In 2002, end of y2k was blown out of proportion as end of IT spending. In 2009, global financial crisis was cited as end of BFSI spending. In 2012, it was the turn of “Euro crisis” ruining IT sector. In 2017, it was digital, automation and AI that will bring end to traditional IT business model”

Below chart captured this brilliantly. It shows, how narrative amplifies the otherwise cyclical downturns into a colossal catastrophe to create great contra investment opportunities for someone who keeps an eye on cycles, not on narratives that follow. This is not to, of course, claim that there are no structural challenges for the sector. As the sector matures and becomes sizable, structural headwinds do come and can’t be wished away. Current structural challenges and the matured size have brought down the sector’s sustainable long-term growth to single digits. The point here is to illustrate how, within the trend-line growth, opportunities are created because of over blown narratives that depresses the stock prices whenever cyclical low happens within the trend-line growth.

Investing is at its best when narrative goes negative.

“Time to invest is when drums are beating, not when trumpets are blaring”

Follow the cycles (mis-pricing), not the narrative for the superior results in investing.

Happy Value Investing!!