There are three important aspects of market movement: momentum, magnitude, and mean reversion. Newton's three laws of motion serve as an apt metaphor for understanding these phenomena.
Newton's First Law states that in the absence of an external force, an object in motion will continue to move in a straight line, while a stationary object will remain at rest. This illustrates the law of inertia, which, in investment terms, can be referred to as "momentum".
Momentum is considered a critical factor in investing. For example, over the past 12 months, we have observed significant movements in small-cap, mid-cap, PSU, and defence stocks. Initially supported by improvements in the domestic economy and subsequently fuelled by earnings growth and positive news, these sectors experienced growing optimism, which eventually escalated to euphoric sentiment. Over the past year, the broader market, represented by the NSE100 TRI, rose by 39 percent, while the market capitalisation growth of the aforementioned indices outperformed significantly, as shown in the table below.
How can inflows lead to such a significant increase in the market capitalisation of a particular sector or market segment? The answer lies in Newton’s Second Law. Newton's Second Law of Motion states that the acceleration of an object is directly proportional to the force acting upon it and inversely proportional to its mass. Essentially, this means that the greater the mass of an object, the more force is required to accelerate it. In our context, the "force" represents market inflows while "mass" corresponds to market capitalisation.
As shown in the table below, as of August 31, 2023, Nifty India Defence TRI was having market cap of just Rs 6.9 lakh crore and Nifty 100 TRI indices had Rs 991 lakh crore. The larger the market capitalisation of an index, the more inflows are required to move it to higher levels.
For indices like Defence and Small Cap, which have lower market capitalisations and low float as compared to others, higher inflows can cause them to become overvalued more quickly than would be justified by their earnings growth over the same period.
Lastly, and equally important, is Newton's Third Law, which states, "For every action, there is an equal and opposite reaction." In investment terms, this phenomenon is known as "mean reversion." While the first two laws are based on trends and "flows chasing the trend," the concept of mean reversion comes into play when a trend reverses due to a negative trigger or an opposing event that contradicts the previous trend. This is analogous to Newton's Third Law of Motion, where the most overvalued segments are impacted the most adversely.
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There may be debates around valuation, with some arguing that future growth could be exponential, and therefore, the current valuations are justified and should not be considered overvalued based solely on historical price and profits. However, just like a movie where we can watch trailer before the full movie, the market often provides hints of what is to come.
Recently, we observed two negative market-specific events, one local and the other global. The first event occurred on June 4, on election result day, and the second was a global sell-off triggered by the "yen carry trade" between August 1 and August 5.
The negative surprise caused by the election results could still be considered an event that might adversely impact sectors such as PSU and defence more significantly. However, the effect of the global event due to the unwinding of the yen carry trade also yielded similar results, as observed in Table B.
It is important to note that sometimes individual stocks may behave very differently from the sector to which they belong. Therefore, a bottom-up stock-picking approach can produce exceptional results even if the broader sector is performing poorly.
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All three factors—"Momentum," "Magnitude of Flows," and "Mean Reversion"—are crucial considerations when investing.
The writer is Co-Head - Products, WhiteOak Capital AMC
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