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On Yahoo: Here Comes The Rally

I write at Yahoo: Here Comes The Rally:

For a stock market that is nearing all-time highs, it is indeed surprising that most retail investors have missed the rally. And the rally in the indices has only just happened; smaller stocks (mid-caps and small-caps) have had a stellar run, returning about 200% in the last year. Before I continue, let me admit that I am one of those that has, for the most part, missed it, and have continued to lower stock allocations to the point where I have less than 50% equity in my portfolio.

There is a saying – “It’s not a sin to be wrong. It’s a sin to stay wrong.” Is the fear of another stock market crash, so fresh in our minds since 2008, completely unfounded? Is there something wrong with holding back now, waiting for a “pullback”? Yes, we’re at levels that seem to be a bubble, but bubbles can go a long way before bursting. In his famous 1996 speech, Alan Greenspan mentioned that stock prices may be “irrationally exuberant” and yet, the markets doubled in a few years and haven’t ever dipped below that “irrationally exuberant” level since!

There are many approaches to investing in the markets today. You can choose one of them, all of them, or none of them and invent your own. We hope you will tell us new and innovative approaches, except those involving a ritual sacrifice of small animals. [Well, unless they are delicious…]

The Kal-Madi Approach

You put all your non-emergency money in stocks. Then if the market goes up, you laugh at all those people who didn’t follow the Kal-Madi approach. If the stock market falls, no one will blame you, because you can blame a bad monsoon, a good monsoon, a defeatist media, a negative attitude, or any randomly invented reason. Some stupid people will point out that they were in cash because they knew the market will fall, and see, the market has fallen, at which point you will remind them that it is not really smart to keep money in a fixed deposit yielding 7% when inflation is at 10%. Then everyone will shut up. You will then ask to be bailed out, because there is no way you will ever quit or lose your money, and considering recent history, you will get it. Even if in the end.

The Jugaad Approach

Contrary to popular thinking, this is not the Kal-Madi approach. It involves tapping a few friends in a few select brokerages to find out which stocks they are likely to move, and when one of them moves, feeling deep regret that you didn’t max your credit cards to buy that stock, despite five other “recommendations” not quite working out. Stocks thus recommended could go up 100-200% in a short time, and I wouldn’t ignore this approach off-hand – I’ve seen it work wonders.

The Fundamentalist approach

You attempt to find cheap stocks to buy even in this mad rally. You look at industries doing well, and recent company results showing great growth and the stock prices low in comparison with the growth expected. This is also called correct-thinking approach by many people, but this is where I would remind you, in the light of a certain Ramalinga Raju, that what you think is a good balance sheet may be a figment of someone’s imagination.

But there is no stock cheap, you might say. I beg to differ; let’s take an example. Recently, stock prices of polyester film manufacturers have gone through the roof -up 200-300% in a few months. Demand for polyester film can’t be met with current supply. Some of the big guns have shut down plants in Europe, there is not much new capacity coming on till end-2011, film prices are up more than 20% in the last quarter and expected to continue rising for the rest of the year. Polyester film is in heavy demand, and is used in packaging, solar industry, electronics and even Flat screen TVs. Yet, the Indian companies in the space are trading at Price-To-Earnings (P/E) ratios of less than 10, even though they are likely to grow earnings more than 100% this year. At current prices, these stocks are still cheap in comparison with power companies richly valued for power projects that will come up sometime in the next decade. Oh, there is risk – because such supply pressure in polyester film usually results in overcapacity as new plants come online, high debt can stifle them, and they’re dependent on crude prices for input – but for a short term the current players will make significant profits. At a P/E of 4 to 8 (versus 20+ for most larger cap stocks), you get a margin of safety as well.

And there are many such opportunities.

Disclosure: I own some of the stocks in this sector. I may just be talking my book.

The Stop-Loss approach

Consider a simple rule – Buy, and then sell if stocks fall by over 10% from the highest point. Unfortunately, in the recent past, when stocks fall 10-20% they seem to recover immediately, resulting in a loss-making “whipsaw”, signifying that the stock movement did just enough to make you a loss, but returned right back to where you should buy again . But more often than whipsaws, stocks tend to go higher and higher before retracing – and a 10% drop from the highest price may still result in your seeing a profit.

For example, if you buy TataSteel at 570, and it went up to 630 (as it has recently), a 10% retracement only lets you break even on the purchase. On the other hand, the stock could go to 700 and then fall back to 630, which triggers the 10% retracement exit – and a significant profit on the trade. In a strong trend, you can’t – and shouldn’t – predict the point at which the trend will break; instead, it’s perhaps simpler to ride it with a stop-loss.

A stop-loss approach requires discipline – a stock that looked good at 100 should be even more attractive at 80, we think, so is it really good to get out? The answer lies in the fact that we don’t know all the answers, and if the stock’s gone to 80 the reason might be bad enough to take it to 40, and the reason will usually appear a while later. (Note: Real estate stocks have fallen more than 60% since January 2008, despite the index recovering to the highs)

The Disciplined Investing approach

Too many people are still unconvinced with the rally, thinking that we are again in a bubble, and that the markets will crash again. That either makes them take money out, or at least, stops them from putting more money in. Yet, if they’re thinking of a 30 year timeframe, they don’t have too much of a choice – fixed income gives you lower returns than inflation, so money has to go into risk assets. To them, I would recommend allocating money every month to the markets, regardless of where the market is; and if you get that instinctive feeling that markets are cheap, go on, put some more money in. The discipline of dividing your money into monthly investments gives you at least some exposure to the markets, and reduces the fear of a large lumpsum losing its value in the volatility that jitters markets every day.

The “Technical” approach

Prices of stocks show specific patterns, time and time again; there’s a way to invest purely looking at prices and volume, a field called “Technical Analysis”. Price patterns may be as simple as “Stocks tend to go higher after they reach all-time highs, ” – before you write it off, note that this simple strategy has made people ridiculous amounts of money. Price patterns can be very simple – like a 20 day moving average, which is simply the average of the last 20 days plotted as a smooth line in history, providing a context of whether a stock is worth buying based on how far a stock is trading away from its “20DMA”.

Or they can be incredibly complex, like “Elliott Wave Analysis” which has the additional benefit that no two people ever have the same view about a price chart and what the current “wave count” is.

Technical analysis is large
ly based on the assumption that stock prices reflect investor sentiment, and it’s possible to make a reasonable bet on where prices will go if you are able to read price charts well. Remember, you could be right only half the time, but if you make 2X when you when and only lose X, you’ll be a net winner.

Of course, one could overdo it and see scary patterns in everything.

* * * *

Investing in a very volatile market can be scary, remunerative or both, and I would heartily suggest you have a plan in case you’re going in. I’m working with a combination; the technical and fundamental approaches with a stop-loss. I do often trade on the short side as well, but we’ll leave that for another day.

What one should watch out for now is the consensus that stocks will go up; when targets like 50,000 Sensex and 10,000 Nifty become front-page news, the market will surprise on the downside. Right now, it looks like there are just too many skeptics.

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