The Signal: Critics vs. Believers: The Game Nobody Won At!

It was 23rd March 2020 and major Indian indices gave way. The darling duo – NIFTY & SENSEX managed to hold itself still only after a free-fall of almost 40%. 

Cut to today, the duo has managed to recover a lot of lost ground. In fact, to put a number to it, it has managed to trek upwards by almost 50% from its low four months back.

While the slump, as well as the uptick, have made for equally sensational headlines, the unfortunate part is that it has left investors more puzzled than before. 

I have spent the last couple of months speaking with more investors than I did in all of last year. Most retail investors (excluding the outliers) can be grouped into two basis their opinion on recent index performance. 

1. The Critic: There’s irrational liquidity flowing into the market. The index is a façade. The market is due for another round of correction.

Now may not be a good time to invest in equity mutual funds.

2. The Believer: The Indian economy is showing signs of recovery, maybe that’s what the indices have already priced in. Guess it’s too late.

Now may not be a good time to invest in equity mutual funds.

Isn’t it funny how two completely contrasting opinions could result in the same conclusion?

At this juncture, my opinion on the most popular opinions is going to be just another opinion. So, let me comment on the conclusion instead.

Now is a good time to invest in equity mutual funds.

I know, you almost saw that coming. But I also know that you’re still inquisitive about what is it that ‘The Believer’ as well as ‘The Critic’ missed!

Here’s what you know, and probably don’t.

Indian capital markets are home to over 5,000 listed entities. 

The NIFTY represents 50 stocks – which is < 1% of the listed entities. (SENSEX represents 30 stocks)

Now, these are the bluest of all blue chips that the bellwether indices represent.

Taking a step closer, you will notice that every stock on the index has a different weightage assigned. Considering NIFTY; for instance, Reliance Industries constitute 12.45%, HDFC Bank constitutes 10.65% and so on till the sum of weightages assigned to the 50 stocks sum up to 100%.

The index performance is an average of how every stock on the index has performed. Weighted average – in line with what per cent does the stock represent on the index.

Here is a brief illustration of how index performance works:

This brings me to my next point.

Continuing the example illustrated above. 

1. How do you think will the index returns move if Stock A’s performance is increased by 20 percentage points to 50%? The overall returns will move up to 33%
2. How do you think will the index returns move if Stock C’s performance is increased to 50% instead? The overall returns will move up to 31%

You would have noticed that though both stocks A and C were considered to deliver a higher return – 50%, the index moved higher when Stock A delivered the uptick and not as much when Stock C delivered the uptick.

This is how weightages and performance of individual stocks matter. For the untrained eye, it may seem like the index has done well when, in fact, it is just the heavy-weighted stocks doing well.

Getting to NIFTY.

Here’s a representation of what happened since the dreadful drop towards the end of March’20:

As can be observed, ~60% of the uptick in the NIFTY was delivered only because the top five stocks in the index performed extremely well. In fact, >75% of the uptick can be attributed only to the top 15 stocks in NIFTY.

Trivia: Reliance Industries Ltd. made headlines for raising a huge round of capital funded by large global investors. The effect was seen in the stock price as it soared by ~125% in the period illustrated above

Remember, there are at 5,000+ listed entities in the Indian capital markets out of which Indian mutual funds invest in shares of ~1,500 companies. This includes the 50 companies listed on NIFTY. NIFTY’s performance has been driven largely by the performance of 5 companies.

Are you a critic? Do you still think that the broader market has peaked?

Are you a believer? Do you still think that the market has completely priced in/reflects the impending economic recovery?

Why don’t you write to us and share your thoughts on how do you perceive the index’s recent performance? We would be glad to hear you out!