The stock market is completely broken. Prices are jumping up and down mindlessly. A broken market is the one that implies irrational outcomes. You would be amazed to see some of the irrationalities the market is shrieking and screaming at all of us right now. Does Implied volatility suggest that people in the markets believe the expected value of Nifty will be less than zero within a year? No, asset price can become negative. That's the level of irrationality.
Implied volatility is the price of uncertainty discovered by contest between traders, investors and everyone involved with markets.
Statistically speaking implied volatility is one standard deviation of the market-implied returns.
Let us do a simple hypothesis test if the marketmen are not implying that Nifty will go below zero or not.
Null Hypothesis, No: Nifty will be less than or zero in 1 year.
Alternate Hypothesis, No: Nifty will be more than zero in 1 year.
(Nifty1YearLater - NiftyRightNow) / Standard deviation = Z Score.
So if the current Market Price is 9300 or whatever randomly fluctuating value we input that value both in the numerator as well as the denominator and basically divide the expected return by implied volatility (since Implied Vol is the standard deviation of expected returns) to calculate the Z score.
Inputting the values,
Z-score = (0-9300)/97.67%
For a 5% level of statistical significance, unless Z score is more than 2 or less than -2 we fail to reject the Null Hypothesis. In statistics, philosophy or even in law there is no evidence for truth. Evidence is always pursued for untruth. If we fail to find evidence of untruthfulness, we have failed to falsify the conjecture and then it must be held true.
We, therefore, fail to reject the Null Hypothesis that the stock market believes it will go below or even lower within one year. The Alternate Hypothesis that the stock market believes it won't go to zero or lower thus cannot be considered.
This is the abyss of irrational pessimism. Can we get more irrational than this ever? The stock market is thus broken and not merely down. What is currently prevailing is not merely volatility but violence.
The urgent measures the government can take immediately are as follows:
1.Shut down the stock markets on the grounds of protecting the employees and executives of stock exchanges and put them into social isolation, since we want our stock markets up and running again once things are normal and not impaired forever or for too long a time.
2. Until the exchanges are shut down, ask the financial institutions to aggressively sell volatility until the implied vol comes down below 50% (the fulcrum at which the market mathematics breaks into being irrational) against the very vast holdings of physical stocks all institutions hold.
The design of markets is to maximise the number of minds feeling they are incorrect. That's how the markets ensure that there are always people willing to contest a price and provide liquidity. But this liquidity mechanism of markets serves its purpose only when the market is within the confines of a rational contest.
The only way out there to bring markets back from an abyss of irrational pandemonium is to shut them down.
When markets are shut down, each participant gets to become separated from the herd mentality and this short break always helps the doubting Thomas in each mind to re-check its participation in the ongoing madness.
Rational and realistic behaviour returns to markets only when the madness is broken. Isn't it simple, a mad man needs to be confined away from the society into an asylum? Put the stock markets away into a short asylum for them to heal.
(The author is the Founder of market-research firm KEDIANOMICS.)