5 statistical tools for stock market investing

Updated - March 02, 2024 at 05:39 PM.

Mean, standard deviation, alpha, beta, correlation: Here are 5 statistical tools to
help you take informed investment decisions
By MADHAV SURESHBL RESEARCH BUREAU
In the ever-evolving landscape of equity markets, with more than 5,000 stocks
in BSE, investors face the daunting task of navigating dynamic waters while
seeking profitable opportunities. In such a context, a key tool to understand
markets/stocks and make informed decisions can be statistical measures. From
the foundational arithmetic mean to the nuanced interpretations of stock beta
and alpha, statistical tools offer invaluable insights into market behaviour and
risk management.
With the immortal words of W. Edwards Deming echoing in our ears, ‘In God
we trust; all others must bring data,’ we present here certain statistical measures
to help you understand the risk-return assessment of stocks.
Arithmetic Mean
Following each company’s earnings release, analysts tend to revise their
estimates, incorporating the latest performance ratios and forward guidance.
‘Consensus estimates’, a term that bl.portfolio readers would have come across
in our analyses, is simply the arithmetic mean (commonly referred to as the
average) of all the estimates.
Consensus estimates represent a collective forecast of a company’s earnings,
aggregating the insights from all equity analysts covering that company.
Consequently, when a company’s results align with or surpass these consensus
figures, they tend to be interpreted positively by the market. Conversely, falling
short of these estimates can elicit a negative market response. Though it can be
calculated manually, it is usually referred from a financial database such as
Bloomberg, which computes by taking a simple average of broker estimates
updated in the last 12 months.
In general, the arithmetic mean can be used both in fundamental and technical
analysis of stocks. It provides a snapshot of the central tendency of a set of
values, say, valuation metrics such as stock PE. For instance, one would often
expect a stock’s PE to generally revert toward its historical average over time,
as per the mean reversion theory.
Limitations: However, exercise prudence when interpreting such averages.
While the arithmetic mean serves its purpose, it has inherent limitations. Firstly,
it treats all data points equally, disregarding potential outliers or skewed
observations. For instance, isolated instances of large price spikes can
disproportionately influence the average return, distorting the overall
perception.
Secondly, while historical performance offers valuable insights, it’s not the sole
indicator of future returns. External market dynamics and intrinsic company
fundamentals wield significant influence over future trajectories. Alternatives
include the geometric mean, which is often used for investment returns as it
accounts for compounding effects better than the arithmetic mean. Let’s say
your stock price doubled (100 per cent returns) in the first year but lost 50 per
cent in the second year. The arithmetic mean of the returns over the two years
will give you 25 per cent. In contrast, the geometric mean of the returns (also
known as the CAGR) will just be zero!
Standard Deviation
Often, you would have heard market commentary that the stocks trading above
2 sigma levels are potentially overvalued. But what exactly is that sigma? It is a
Greek symbol representing standard deviation (SD) which is a vital tool to
assess the volatility and relative stability of a stock’s price movements. It
quantifies the extent to which a stock’s price tends to deviate from its average
closing price. A high SD implies heightened volatility, characterised by frequent
fluctuations in stock price, while a low SD signals more stable price behaviour.
By combining the concepts of mean and SD, one can establish thresholds
beyond which deviations from the average are deemed significant. Typically,
these thresholds are calculated as mean plus (or minus) one SD and mean plus
(or minus) two SD.
Over a long period, it is assumed that the distribution of any data, such as stock
PE, tends to approach a normal distribution, according to a statistical concept
called the Central Limit Theorem. Simply put, the stock PE data will closely
resemble a bell curve pattern. For instance, if you were to collect the heights of
a large random sample of adult males or females from a given population and
plot them on a graph, you would likely observe a bell-shaped curve, with the
majority of individuals clustered around the mean height, and progressively
fewer individuals of very tall or very short heights as you move away from the
mean towards the extremes.
Once this is settled, the three-sigma rule (also called 68-95-99.7 rule) then states
that 68 per cent of the data will fall within the first SD from the mean, 95 per
cent will fall within two SD, and 99.7 per cent will fall within SD.
Let’s break it down with an example. Consider Infosys’ Price-to-earnings (PE)
ratio over the past two decades. By calculating the mean and SD of this metric
and plotting it alongside the threshold bands, we get interesting insights.
Notably, instances where Infosys’ PE ratio exceeded the mean plus 2SD, such
as in 2006-end and March 2022 as seen in the chart, hinted at potential
overvaluation relative to historical norms. Going by the three-sigma rule, we
can say that there is a 95 per cent probability that the stock PE will revert below
the mean plus 2SD band. Indeed, as evidenced in the case of Infosys,
corrections in the stock’s PE ratio have historically materialised following
breaches of the mean plus 2SD threshold (see chart).
The stock offered a buying opportunity whenever it breached the mean minus
1SD band — in October 2008 and April 2020. Between 2012 and 2020, the
stock PE was hovering around the mean and mean minus 1SD band, implying a
consolidation phase.
Limitations: However, while the mean plus 2SD threshold band serves as a
valuable benchmark to assess stock valuation, it’s imperative to consider a
myriad other factors — such as the company’s growth trajectory, the quality of
its earnings, industry dynamics, macroeconomic variables, and broader market
sentiment. Also, a high P/E ratio alone does not necessarily signify
overvaluation. Instead, you should evaluate whether a premium in the stock’s
valuation aligns with the company’s future growth prospects and intrinsic value.
Beta
Though SD helps you understand the dispersion of a stock’s returns around its
mean return, it lacks a comparative aspect against the broader market, which is
where the beta metric comes in. Beta enables investors to assess the systematic
risk inherent in a stock. A beta value greater than 1 suggests that the stock tends
to be more volatile than the market, implying larger price fluctuations.
Conversely, a beta below 1 indicates lower volatility compared to the
market/benchmark.
Typically, stocks with higher betas present potential for amplified returns, albeit
with heightened risk. Hence, if you have a higher risk appetite, then you might
consider such high beta stocks, anticipating greater returns, while those
preferring conservative investments may opt for lower beta stocks.
Take the case of Fast-Moving Consumer Goods (FMCG) and Consumer
discretionary industries such as automobiles. Hindustan Unilever (HUL), a
prominent player in the FMCG sector, typically exhibits a low beta of 0.51
(considering a 20-year weekly period). This low beta can be attributed to the
essential nature of its products which fall under the consumer non-discretionary
category. Conversely, companies in the consumer discretionary sector, such as
Tata Motors, often boast higher betas owing to their sensitivity to economic
cycles, consumer sentiment shifts, and commodity price fluctuations. Tata
Motors holds a higher beta of 1.35 — evidenced by its 52-week highs and lows
of 977.2 and 401.7, respectively.
Moreover, even within the same industry segment, stocks can exhibit varying
beta values. Take Maruti Suzuki and Tata Motors, both operating in the
automobile sector. Maruti Suzuki has a beta of 0.9, while Tata Motors’s beta is
greater than one. These discrepancies can stem from differences in business
models, market positions, capital structures, and many other factors. While beta
can be manually computed, it is readily available in various financial databases
such as Bloomberg (paid) and Refinitiv (paid), stock market analysis websites
such as Ticker Tape (paid), and a few brokerage firms, including 5paisa (free).
Limitations: While beta can give you an idea of how a stock moves relative to
the market, it’s not a perfect measure because it’s based on past data which may
not reflect future performance accurately and doesn’t consider all the factors
affecting a stock’s performance.
Alpha
In 2023, amidst a buoyant global market backdrop, the Indian bellwether
indices exhibited robust performance, surpassing many of their global
counterparts. Despite the overall positive returns witnessed across various
stocks, one should understand that mere raw returns do not provide a
comprehensive picture considering risk.
Instead, the concept of alpha offers an evaluation of performance which
considers the excess return you might get from a stock beyond the market
returns. But this does not consider the risk taken to obtain the higher returns and
whether the returns are commensurate to the risk. Here, alpha computed using
the Capital Asset Pricing Model (CAPM) provides a method to assess a stock’s
risk-adjusted returns. This model helps us predict how much return an
investment might give us based on different factors — such as the risk-free rate
(returns from government bonds) and the market risk premium (the extra return
you get from investing in stocks compared to safer options). By using CAPM,
we can estimate how much return we might get from an investment by
multiplying its beta (how volatile it is compared to the overall market) by the
market risk premium and adding the risk-free rate.
For instance, in 2023, the India 10-year government bond yielded an average of
7.21 per cent, representing the risk-free rate, while the Nifty 50 index yielded
returns of 20 per cent, signifying market returns. Employing CAPM, the
expected returns for Infosys, with a beta of 0.66 (considering a 20-year weekly
period), were projected at 15.7 per cent. Conversely, Infosys delivered a meagre
return of 2.3 per cent during the same period, resulting in a negative alpha of
13.4 per cent.
Limitations: While stock alpha provides insights into a stock’s performance
relative to its risk level and the broader market, it has limitations due to its
reliance on model assumptions, sensitivity to data quality, short-term focus,
susceptibility to market conditions, and limited scope of analysis.
Correlation
Correlation plays a vital role in various aspects of day-to-day life, influencing
decision-making, and understanding patterns in different phenomena. In
financial markets, it can be exemplified through the analysis of stock prices,
where analysis of correlations between assets can add value to investment
strategies and portfolio diversification efforts.
Visually, through scatter diagrams, one can see whether the prices of two stocks
move in tandem or exhibit contrasting movements. When prices move
concurrently, we identify a positive correlation; conversely, if one stock’s price
ascends while the other’s declines, a negative correlation is indicated. We infer
no correlation between the stocks if the pattern is just random.
Mathematically, quantifying this correlation entails the calculation of a
correlation coefficient, a measure bounded between -1 and +1 that encapsulates
the extent of co-movement between the returns of two stocks. For instance,
among various BSE sectoral index returns over a two-decade period, the
correlation coefficient between the IT and FMCG sectors emerged as the
lowest.
The IT sector is often considered cyclical, experiencing periods of rapid growth
followed by downturns or consolidation phases, influenced by factors such as,
say, the digital boom or the global slowdown. FMCG companies, being
providers of essential consumer goods, are less cyclical and are considered
defensive investments, with relatively stable demand even during economic
downturns. An investor can make use of this opportunity for sector rotation to
capitalise on changing market trends or diversify his/her holdings to minimise
the overall risk of the stock portfolio.
Beyond individual stocks, correlation also helps you to construct diversified
portfolios by assessing the relationship between different asset classes. If we
look at the MCX gold future prices and Nifty 50 over the past 20 years, we
notice that their prices were inverted between 2011-14 and 2020-22 with the
correlation coefficient between their weekly returns being -0.03. Asset classes
with low or negative correlations tend to move independently of each other,
providing better risk mitigation when combined in a portfolio. Diversification
helps reduce overall portfolio volatility and enhances risk-adjusted returns.
Limitations: While correlation can give us insights into how stocks move
together, it doesn’t imply causation. In a famous example, researchers found a
surprisingly high correlation between butter production in Bangladesh and the
movements of the S&P 500 index. Despite there being no logical connection
between Bangladesh butter and US stock market performance, the correlation
appeared strong over a certain period. This was purely coincidental and didn’t
indicate any causal relationship.
Goldman Sachs predicts Nifty50 surge to 23,500 by December 2024
Updated - February 19, 2024 at 09:01 PM. | New Delhi
Strong Earnings Growth Foreseen as Primary Catalyst; Market Stability
Anticipated Despite General Election Results
BY KR SRIVATS
Foreign brokerage Goldman Sachs sees Nifty50 scaling up to 23,500 by end-
December 2024 even as it does not expect any large market moves around the
upcoming 2024 general elections outcome.
The surge in the benchmark index will primarily be driven by the strong 15 per
cent earnings growth and supported by the high domestic inflows, Santanu
Sengupta, Senior Asia Economist, Goldman Sachs India and Sunil Kaul, Senior
Asia Equity Strategist, Goldman Sachs Singapore said in a recent note.
Equity markets have historically traded well heading into the elections, with
Nifty rallying more than 10 percent in the six months preceding elections in
four of the past seven general elections, they noted. “With the roughly 15
percent rally in Nifty since November and market expectations of policy
continuity priced in, we don’t expect large market moves around this election
outcome”, they said.
On a roll
India’s equity markets have been on a roll since December last year post the
BJP’s State elections triumph and saffron wave sweeping the Hindi Heartland,
adding nearly 2,200 points between December 1 last year and February 19 this
year. Nifty50 on Monday hit an all-time high of 22,186 before closing at 22,122
on some profit booking.
Strong macro fundamentals coupled with a higher fiscal consolidation aim for
2024-25 in recent interim budget has also boosted investors’ confidence and
fuelled equities rally. However some market watchers contend that Indian
benchmark indices and the broader market as well may be overvalued at the
current levels.
Most analysts point out that the 3QFY24 corporate earnings have exceeded
expectations, with the BFSI and automobile sectors driving the overall
performance.
Sengupta and Kaul highlighted that Indian general elections have historically
been an important driver of financial markets. “While earnings will primarily
drive the market, we expect the flow backdrop to remain supportive as domestic
inflows remain high amid the rapid financialisation of household savings and
foreign inflows are likely to pick up further after the elections, in line with prior
election cycles”, they added.
Sengupta and Kaul also said that past pre-election rallies, which occurred on
expectations of a stable government, were led by domestic cyclicals.
Growth and inflation
Goldman Sachs does not expect India’s economic growth to increase following
the upcoming general elections given the slowdown in government spending
that it anticipates this year amid fiscal consolidation efforts.
On the inflation front, Goldman Sachs expects inflation to increase after the
election. However, it doesn’t expect it to happen until the fourth quarter, as it is
of the view that food inflation will remain relatively benign until then. “Over
the last four general election cycles (2004, 2009, 2014,2019), both economic
growth and headline inflation, on balance, declined marginally heading into the
elections and increased modestly thereafter”, Goldman Sachs note added.
RBI policy
Sengupta and Kaul highlighted that historically, the RBI eased policy heading
into the elections and didn’t hike policy rates for at least nine months after the
elections. “We expect the RBI’s easing cycle this year to begin in stages, with
the RBI first changing its policy stance from ‘Removal of Accommodation’ to
‘Neutral’ and easing banking system liquidity in Q1/Q2, followed by 25 basis
points rate cuts in each of Q3 and Q4, which would bring the policy rate to 6.00
per cent by the end of 2024”, said the recent Goldman Sachs report.
YES BANK
Yes Bank is back to its peak market cap of $10 bn but still share price is far
away from the peak
Here is why
An important lesson on Equity Dilution..!
Context - Yes Bank used to trade at a adjusted share price of 300-400 with a
market cap of $11bn in 2017
Cut Back to 2024, its market cap is back to its peak of $11bn but share price is
still almost 90% down from the peak
Many people are wondering why?
The answer to curiosity lies in the concept of Equity Dilution
Equity dilution is defined as the decrease in equity ownership for existing
shareholders that occurs when a company issues new shares.
Yes Bank did restructuring and fundraising multiple times which led to 10x
growth in no of shares including corporate actions like bonus splits.
Now, Equity Dilution is not a good thing in the business.
Basically, it simply means the company is in continuous need of funds like we
see in start-ups.
If a bank or NBFC is in continuous need of fund raising through equity this
means there are issues in underwriting and loan book
Coming to Yes Bank
Yes Bank did restructuring and raised funds through FPO which led to a
significant rise in no of shares - A heavy equity dilution happened.
While the company reached its peak market value it has not helped investors in
recovering their losses because of equity dilution. Since today every shareholder
in Yes Bank holds 10 times lesser stake than he used to hold in the restructuring
era.
PAT in million, No. of Shares in lakhs, FV ₹2
12/02/2024