Nomura’s new proprietary indicator developed by its quant team called Nomura Economic Surprise Index for India (NESII) is designed to help investors predict whether stock market will turn bullish or bearish. It has
Beating the stock market is tough. With a torrent of information flowing in daily, how can an investor or portfolio manager sift through all the noise and come up with an effective signal to guide trading and investment decisions? How do they deal with stock economic surprises? For example, traders and investors are often overloaded with information such as inflation (wholesale price index), Index of Industrial Production and GDP, which are announced at different points of time and have a significant effect on the stock market direction and movement. If positive news is contained in these numbers, stock markets and bond markets will move up and vice versa. Sometimes, the data disclosed can be wrong and can harm investors. Many a times, in India, we’ve noticed that IIP numbers have surprised investors only to find out that later it is only a blip. Will the surprise lead to a stock market trend over time? Will the surprise turn around the stock market? Does lower inflation really mean that the economy has rebounded, or is it a flash in the pan? All these are pertinent questions to be answered, but aren’t easy.
To equip investors to deal with this, Nomura has come up with a proprietary indicator called Nomura Economic Surprise Index for India (NESII) which is used as a “tactical tool” to gauge investor sentiment and to help predict key turning points. Nomura says, “NESII is a single numerical index which crystallises the relationship between markets and economic data in India, and tracks the direction and magnitude of economic data surprises.”
NESII is a weekly index which has “shown a strong correlation with India’s financial markets and can be used to reaffirm nascent price movement.” In other words, it is used to predict bullishness and bearishness of the stock market vis-a-vis market expectations and surprises. Sometimes, the gap between investor expectations and actual facts can be so large that it can potentially be a turning point. Again, it may not be. NESII is a forward indicator which aggregates and normalises the market ‘surprise’ of certain key economic data to gauge sentiment so that the portfolio manager can decide the investment plan. Consider the chart below.
It shows NESII and NESII 3-month moving average. The idea is that if NESII goes over zero, then it could be taken as a sign of turning point and a bullish trend reversal and positive sentiment which will further lead to good mood and could lead to euphoria. Likewise, if it goes below zero, expect markets to fall as negative surprises build up, you guessed it, negative sentiment, which will drag the market further downwards.
Here is an interesting chart of how NESII behaved in relation to the GDP
This shows how sentiment can affect the market. As you can see—between October 2008 and October 2009, the sentiment went up and NESII mean-reverted above zero. At the same time, the GDP was depressed and actually declined. This should have told investors to stay away from the markets, right? What really happened was that the Nifty picked up from the aftershocks of the sub-prime crisis and went up, thanks to Quantitative Easing by the Federal Reserve. It can also show how irrational exuberance could be at play and whether traders would like to take advantage of such movements. Nomura says, “When NESII starts to mean-revert from extreme levels it sends a strong signal that data surprises will continue in the new direction, and so is an invaluable cross-check for whether or not nascent market rallies or sell-offs will continue.”
How effective is this indictor? For an investor to be confident of an investment tool a lot of back-testing needs to be done. For equities, its success ratio was 72%, with currencies it was 66% and bonds 57%. For the benefit of investors, they may consider trying it out only for equities. Nomura also spoke of its “success ratio” defined as percentage of times NESII correctly mapped the sign (above/below zero) of specific market movement in a given sample space. It also found out that there was positive correlation between NESII and the NSE Nifty market, government 10 year yield and a negative correlation between NESII and the FX markets. For equities, the correlation was 0.67; bonds 0.41; and currencies -0.61. In other words, the NESII behaves closely in fashion with the Nifty Index. A perfect correlation of 1.00 would mean NESII would behave exactly like the Nifty.
Having said this, investors should use it as one of the tools to aid investment plans and decision making. There are many tools, from technical analysis to fundamental analysis to a quant indicator like NESII. Use with caution and only whether you’re comfortable incorporating it into your investment plans and philosophy.
