Caution Must Remain the Watchword
This is the most exciting time in the markets that we have ever seen with the key benchmark indices scaling new heights virtually day after day. It certainly seems as if there is no ‘risk’ in investing. As markets continue to rise, investors are becoming increasingly confident and overlooking concerns by justifying it with hopes of more stimulus packages, infrastructure spending and a vaccine. So, let us talk about the exuberance that we are witnessing on a daily basis. It is believed that, up to some extent, retail investors are responsible for the exuberance seen in the stock markets; this is because speculation is running rampant.
Before we start, we would like to share a simple definition of ‘speculation’. Speculation involves trading a financial instrument involving high risk in expectation of significant returns. The motive is to take maximum advantage from fluctuations in the market. So, what happens when speculation is running rampant? Excessive exuberance, as I believe is currently seen; people stop thinking about the future and only think about the present moment. Ideally, when an investor purchases the stock of a company, he becomes a part owner of a company, but when a speculator purchases a stock, he is not concerned with what the business might be worth in the next couple of quarters or may be couple of years down the line.
What is more important to him is what somebody is willing to pay for the shares today and tomorrow. The vicious circle of speculation goes this way: the higher the prices go, the more eager people are to buy. The more eager people are to buy, the higher the prices go. And the higher the prices go, the more eager people are to buy. Isn’t this what we are witnessing right now? Think about the rally which we are witnessing in some of the suspicious stocks which have no revenue visibility or the fact that they don’t know how they are going service their fixed costs obligations in future. But these stocks seem to be running wild and simply shooting through the roof on huge volumes amid speculation running rampant.
What is more important to him is what somebody is willing to pay for the shares today and tomorrow. The vicious circle of speculation goes this way: the higher the prices go, the more eager people are to buy. The more eager people are to buy, the higher the prices go. And the higher the prices go, the more eager people are to buy. Isn’t this what we are witnessing right now? Think about the rally which we are witnessing in some of the suspicious stocks which have no revenue visibility or the fact that they don’t know how they are going service their fixed costs obligations in future. But these stocks seem to be running wild and simply shooting through the roof on huge volumes amid speculation running rampant.
As economist Ben Graham points out, the biggest difference between a speculator and an investor is that the investor can protect himself by margin of safety, while in speculation there is no margin of safety. This is why one needs to act as an investor and not as a speculator. Talking about the trend of the markets, the bullish trends remain intact. The FII inflows are favourable and the price structure, indicating that the market could continue with its momentum in the near-term. That said, the markets remain significantly overbought and remain grossly extended from long-term mean (200-DMA).
Currently, the index is trading nearly 30 per cent above its long-term mean i.e. 200-DMA. The only other times we have seen the index overstretched from its 200-DMA was back in 2007 and 2009. And, in the past we have seen that these overstretched periods often result into the loss of shortterm gains rather quickly. A correction within the next two months would not be surprising given the deviation from the long-term mean. Consider also the fact that in the last two decades we have seen markets peaking out 16 times in the first quarter of the calendar year. Meanwhile, maximum number of tops has been witnessed in the month of January, i.e. nine times, followed by four times in February and three times in March.
As such, it is time to tighten risk management and be cautious. However, this does not mean we may not move higher from the current levels. As a trader and investor it’s important to keep in mind that we do not attempt to predict the market – that’s a futile endeavour. We instead react to what the market is telling us and at the current juncture with volatility at an inflection point and history indicating that in the month of January we have seen markets peaking maximum number of times, the need of the hour is to remain watchful. Considering all such factors, it makes sense to avoid leverage positions and to have a strict stop loss for all the long positions. Going forward, the trend of the market would be dictated by FII inflows while stock-specific actions will be based on Q3 earnings, which is about to pick up steam.
