Law of Averages,Regression to the Mean and the Walk down the Dalal Street!

 Sir Francis Galton, a British polymath, did pioneering work on Regression or Reversion to the Mean in Statistical Research in the late 19th Century. According to his analysis of human characteristics, he applied statistical methods to the study of human differences and inheritance of intelligence and pioneered the work on Eugenics. He also contributed to the field of psychology by founding psychometrics with personality mapping.

He was a versatile genius and being the half-cousin to Charles Darwin, his works in many ways drew sufficient inspiration from Darwin's studies. But his most outstanding contribution is Regression to the Mean in Statistical analysis. He is also considered to have developed a central limit theorem showing that with sufficient sample size the binomial distribution approximates a Normal Distribution and the practical demonstration of it is called Galton Board or Quincunx or Bean machine

Regression to the Mean is in simple terms that if there is volatility observed over the mean, over a while the values will show Regression to the Mean/Average and Francis Galton termed it as Regression to the Mediocrity in terms of inherited human characteristics. This led to modern statistical modeling based on linear regression analysis.

Regression to the Mean is also important to understand the stock market behaviour. Stock market behaviour is considered to be a Random walk and the financial world which considers a normal world will always look for stable returns. Jeremy Siegel said that "return to the mean" may show that returns may be unstable in the short term but stable in the long run. In such a situation the returns can be easily quantified and not a Random walk. But the stock market exhibits typical Random Walk characteristics. A Random Walk is one in which future steps or directions cannot be predicted based on past actions or performance. But Dalal street would hate to call its three-piece suit executives , who carry an air of super cat financial strategists,  as "Random Walkers"!!(link). The central hypothesis of Random walk is that one cannot consistently outperform the market averages. In other words, even the best of financial strategies would eventually start regressing to the mean.

The law of averages which is a law of large numbers gives false belief and therefore it is called "Gamblers' fallacy". It leads to the misconception that the probability of an outcome occurs with a small number of consecutive experiments so they will have to "average out" sooner rather than later. This is the fallacy that rules the mind of every gambler and that is why it is called "gambler's fallacy". Stock market ups and downs can also lead to this kind of fallacy in the short term.

Dalal Street is a minefield for the uninitiated and a good playground for those who have an appetite for a long walk or for those lethargists who buy indexed bonds, sleepover them and don't go for a walk!!

RBI monetary policy and the state of the Indian economy

 RBI's recent Monetary Policy announcement after MPC considered the latest economic factors, CPI etc , came out with no repo rate cut. Primarily because CPI is elevated and at an uncomfortable level as far as RBI is concerned.since the mandated and stated objective of RBI is now inflation control, RBI has decided to hold the rate this time despite the economic slowdown calling for a steep rate cut.RBI also mentioned that this year would see real GDP contraction after more than four decades, but still decided to save the powder for a more rainy day or for a day when the bang will be worth its buck.

India is facing rising prices also esp. food prices, fuel prices and therefore is experiencing a cost push inflation. There is a school of economists who say the inflation is fueled by easy liquidity floating in the economy and the stock exchange boom , gold price rise all indicate to easy money into areas where some quick money can be made.Even RBI is predicting a rise in inflation levels in Q2 but has refrained from an inflation forecast.

Gold price,as Ruchir Sharma in today's TOI blog(link )puts it, rises due to uptick in demand whenever interest rate is lower than the inflation rate. But Gold being a safe haven investment booms when the rest of the economy sees more volatility elsewhere esp. in stable investments. There is a rush of outflow from equity MFs in July but is it going to Debt MFs or to stock market or to gold  is anybody's guess.But there is greater desperation driving up buying Gold rather than preference as an investment.

All this paint a confusing story but with tinges of liquidity bulge which may become an inflation down the road, unless the productive resources are used for assets and jobs creation. But the silverlinings are shallow oil prices, decent monsoon, burgeoning foreign exchange reserves and surplus in current account balance. So, cost push factors in inflation are slightly mitigated in the near to short term.

CII 's recent 111th Business Outlook survey,July 2020, which was released last month revealed that out of three indeces Current situation index, Expectation index, Business confidence index, the Current Situation Index of Q1 of Fy 20-21 is similar to the levels of Q4 of Fy 19-20! Only the Expectations and Business Confidence levels in the economy have deteriorated during Q1 of Fy 20-21 as compared to earlier quarter.

Dr.Manmohan Singh in his BBC interview has also clearly said that this human crisis created by the pandemic calls for greater spending and greater borrowings by the GOI, even upto another 10% of GDP for tackling health, military and economic challenges of the country. His wise words would be worthy of listening now.(link)

But this borrowing must have a clear exit clause linking it to FRBM Act requirement of glided fiscal deficit path to 3% of GDP eventually in the short to medium term of 3/4 years. Only this can bring back investors into the country. Otherwise Fiscal profligacy is the scourge of the growing economies like India.

There are no simple answers but quick actions,as outlined by PM in his speech on the occasion of  Ram janmasthan Temple laying foundation,have to be taken by the Govt. Quoting from Kamba Ramayana he said "காலம் தாழ ஈண்டு இனும் இருத்தி போலாம்" என்றான் இராமன்" which essentially means we should not procrastinate taking actions to rectify the situation. A well focused fiscal stimulus, vaccine or no vaccine, is an urgent imperative.