Outlook for global equity markets – Persistence of irrationality

Someone has rightly said, “the best way to lose money is to look for a rational investment strategy in the stock market”.
With markets around the world playing with the nerves of all investor class, be it big or small, no one has the faintest clue as to where we are headed. Each one is looking towards the other for some definitive clues to give some sense of where we are heading but to then its like a blind man guiding another one. The memory of equity markets are very small and with the rally as sharp as the current one having taken everyone by surprise, people are now feeling left out. These are the same people who were all predicting that the worst is yet to come and more downside is there.

Now every 5-10% dip in the markets is seen as a buying opportunity by this same class of ‘investors’ / ‘traders’. It is this class of people who are giving all the support to the markets on the downside. Whether we call it god’s gift or shere irrationality, only time would tell. One thing is for sure,”money can neither be created nor destroyed, it only changes hands”. We all know the old and time tested and all so cliche teaching of wallstreet “buy low sell high”. What is confusing is that there is no scale to measure high and low. what might seem a high for someone, might be the low for another, else there would be no transaction in the first place. If everyone in the market had the same levels in mind, then there would be no buyers at higher levels and no sellers at the bottom. So it is important to understand that value is a measure whose magnitude and boundaries varies from person to person. It is this basic feature which sustains all trades in the world, be it in any form. Equity trades are no less different and as long as this irrationality persists in the market, we could continue to see higher levels in global equity markets, unless we are awaken one fine morning with the realization that all is not well, like the credit burst of 2008! Till then play to the music of the market….

Sideways till the edge of sanity!!

1. We are seeing the Indian markets trade sideways for almost two weeks now. Some say its the lull before the storm while others say its forming a strong base before the next upmove. You may be in either camp, but i would want to be very careful, be it storm or base formation!! Either of the parties could be right, the storm could take us higher or pull us down, the base formation could be the bottom or a plateau being formed and we could fall off the cliff edge!!
   The bottomline remains that we are here to make money in the equity markets. The risk reward ratio should be favourable else it makes no sense guessing the direction of market movement and getting caught on the wrong foot and losing money in the process. This has been the case with many people over the past few months. When they thought, we were set to see a correction and went short on the markets, they burned their fingers. Similarly when an upmove was imminent, they lost money in options as markets traded flat and option premiums eroded due to time value. So what should one do in order to maintain one’s sanity in these markets. Here are a few things which could help the investor class preserve its sanity in these volatile and uncertain markets:
   Understand your risk appetite - Its cliche but should be remembered, higher return expectation would always be accompanied by higher risk. One would say its difficult to gauge one’s risk appetite. I would say ask a few simple questions and the answers would tell you if you are risk averse or high risk taker. Would you prefer getting assured return of 8% per annum with capital protection or a chance to make 25% profit or a loss of 25% (capital erosion of 25%)? If you choose 1st option, you are no doubt risk averse and it is advisable to stay away from equities at these volatile times. If you feel you have the capacity to withstand a 25% capital erosion in the short time, then jump into the equity markets and make a killing but be ready to get rude shocks now and then.
   Play Derivatives safely – Derivatives are like financial time bombs, ready to explode. Don’t buy derivatives with the same mindset as if you are buying a stock. First of all derivatives expose you to leverage and secondly derivatives should be better used for hedging rather than taking naked positions. Options is all the more dangerous as we are seeing in current markets. Option premium erodes drastically with time and with the month end expiry coming close, it would tend to become zero! One safe way to play F&O is, do options for the 1st two weeks of a month and in the 3rd and 4th week play only in futures. This would save you from the pain of losing all the option premium incase your call on markets went wrong.
   Invest for long term – Make two separate portfolios. One for the long term wherein you would keep building the nest for the golden years. The other portfolio could be the short term trading portfolio which would satiate the trading nerve in you. Never mix the two. Quite often what is seen is that you buy something for trading and when it goes into loss you say to yourself “this is a long term investment”. Clearly avoid doing such mistakes. By doing so you are making a long term portfolio of junk (heard on the street type of) stocks. Build quality portfolio for long term and trade on news and rumours for the short term.
   Build cash reserve before trading in equities – Always invest that much money into equities which you would not want to touch in the short term. Remember equities could give you a rude shock in the short term and your hard earned money could remain blocked when you need it in the near term. For short term money, its idle to park it into debt instruments.
   Each investors case varies from the other and it is imperative that one does a thorough self analysis before entering the markets. One simple thumb rule is that play with that much money in F&O which you are willing to lose without getting sleepless nights.
   

The Common Elements Of Success of a trader

In Van Tharp’s latest book “Super Trader,” he provides 10 common characteristics frequently found among the best of the best among the hundreds of traders he’s worked with throughout his career. Like me, I think you may find it of interest!
1. They all have a tested, positive expectancy system that’s proved to make money for the market type for which it was designed.
2. They all have systems that fit them and their beliefs. They understand that they make money with their systems because their systems fit them.
3. They totally understand the concepts they are trading and how those concepts generate low-risk ideas.
4. They all understand that when they get into a trade, they must have some idea of when they are wrong and will bail out.
5. They all evaluate the ratio of reward to risk in each trade they take. For mechanical traders, this is part of their system. For discretionary traders, this is part of their evaluation before they take the trade.
6. They all have a business plan to guide their trading. You must treat your trading like any other business.
7. They all use position sizing. They have clear objectives written out, something that most traders/investors do not have. They also understand that position sizing is the key to meeting those objectives and have worked out a position sizing algorithm to meet those objectives.
8. They all understand that performance is a function of personal psychology and spend a lot of time working on themselves. You must become an efficient rather than inefficient decision maker.
9. They take total responsibility for the results they get. They don’t blame someone else or something else. They don’t justify their results. They don’t feel guilty or ashamed about their results. They simply assume that they created them and that they can create better results by eliminating mistakes.
10. They understand that not following their system and business plan rules is a mistake.

Three Stages of a Bear Market Rally

In April it was clear we were in an incredibly strong rally. At the Prosperity Dispatch, we pegged it as a rally you would want to ride all the way to the end. And it would last far longer than most expect.

We also knew it would be a highly emotional ride. After all, when you’re making 20% or more each month, the common mistake is to sell too early. It’s easy to do. The natural desire to sell for a quick profit is a strong one. But history has shown the biggest gains will be made by those that ride out a trend for all it’s worth.

In mid-April we took a historical look at the Three Stages of Bear Market Rallies, how they begin, how they last until the last bear finally gives in, and specific warning signs to look for to know when it’s coming to an end.
Here are three stages of bear market rallies we identified. As you’ll notice, at the end, all signs point to the current rally coming to an end sooner than later.Stage 1: “This will never turn around.”

The first stage of a bear market rally starts when we get the first signs of a turnaround. This happens when everyone thinks it will never turn around. We hit that point in early March. Since then the markets have been so beat up in such a short period of time that any bit of good news can get things rolling higher again.
As the “Obama rally” turned into a sucker’s rally, each passing week brought progressively worsening economic news. There was nothing to look forward to. Expectations were low and headed lower.

We hit this point in March and once the market started moving up on “not as bad as expected” news, it was clear a bear market rally had begun. And since the S&P 500 was down more than 55% from its 2007 highs, the set-up was in place for an extended, sharp, and lucrative rally.Stage 2: It’s a Bear market rally, “The easy money has been made.”

This is the stage where you’ll see most commentators admit we’re in a bear market rally. Many of them freely cite some warning about the coming rally they issued and it was to be expected. Most of them go on to warn this is a bear market rally and advise against buying now. By May 9th, two months into the rally, the S&P was up 36%. That’s a decent return for two years in a good market. In two months, it’s downright fantastic. By this time no one could deny the rally was real. Anyone, however, could quite easily make a case where the rally had gone too far, too fast and it was too late to get in.

This is also the stage where volatility plays a greater role. The markets quit bounding up day after day and there were real corrections (at least 5%) just to keep the herd on the sidelines.Stage 3 – “All clear! Don’t miss this.”This is the final stage. It’s when the bear market has been forgotten by most investors. It’s when the “panic buying” sets in as the big money fears 1) it has missed all the chances to buy low, 2) their performance will suffer, and 3) customers will take their money elsewhere.

To make up for lost time, they buy more aggressively than ever. This is an extremely profitable stage. Yet when the big money runs out of cash to buy shares, watch out, the end of a bear market rally is near. The clearest indicator we’re in the third and final stage is the stagnating upward momentum. The S&P 500 rose 36% in the first two months of the rally. It rose a respectable 13% in the next three months. It rose 6% in the last three months. The rally appears to be running out of steam. At this time, however, most investors feel more comfortable buying stocks than they have since the rally began. GDP is up, earnings are up, and corporate executives are issuing positive guidance about their near-term growth prospects (most refused to even venture a guess last year).

The “all clear” has been sounded by executives, analysts, and many others. And investors continue to put more money to work (or, from our philosophy, at risk). Last week was the 34th week in a row in which investors put more money into mutual funds than they took out. As for the aggressive, panic-style buying we expected, it has been largely masked by the rebound in share prices. For instance, a mutual fund manager who wants to buy 10 million shares of Bank of America only had to put up $40 million in March. A few weeks ago, the same stake would cost $180 million. As a result, a lot more money may be going in, but it’s having a significantly less noticeable impact.
———————————————————–It’s Never Different This Time
As this rally shows greater and greater weakness, the risk and reward situation continues to turn against going “all in” now. Also, since most of them have the wind at their backs and a renewed confidence, they’re sure they will be able to achieve the nearly impossible and get out at the top. Since it’s never different this time, we know those facts are not going to stop investors from trying either one of them. That’s why right now, the best advice we can follow is what we’ve stuck to since the beginning. Look for sectors with exceptional fundamentals, identify the best risk/reward opportunities in those sectors, develop a plan, and stick to it. Although day-to-day it never feels quite the same and emotions, left unchecked, will quickly cloud out reality, we know it’s never different this time. And there’s no reason to expect this rally to play out any different than every one that has come before it and every one that will come again.