Using reflexivity-based method for stock investing requires strong nerves.
There's an old Wall Street saying; “You can't fight the tape”. The market chooses its own direction. Also, as the great John Maynard Keynes once pointed out, “The market can stay irrational longer than you can stay solvent”.
The investor must live with irrationality and choose a timeframe and a method of deploying money that optimises chances of positive long-term returns. There are many ways to do this. One is to go overweight on defensive stocks such as pharma and FMCG during bear markets. These are stable, non-cyclical businesses with reduced chances of capital erosion during a bear-market. A defensive portfolio will fetch unexciting but steady returns.
Some investors use the exact opposite strategy during bear markets: they buy beaten-down, highly-cyclical stocks. The logic is, there is less potential downside. Such a strategy hopes for spectacular recoveries, as and when the stockmarket turns North. These stocks could fall further of course but another danger is, some beaten-down businesses never fully recover.
The classical theorist says an investor must ignore the twitches of shareprice fluctuations and invest purely on the basis of good valuations and growth prospects. This is easier said than done due to “reflexivity” as it's called.
To understand reflexivity, consider only valuations. There is a range of rational valuations for any business. You can assess the probable future earnings and assign reasonable PE multiples. For example, say a given stock has likely EPS growth of 20-25 per cent per annum. It is reasonably valued at PE multiples of between say, PE15-PE30, depending on the level of optimism.
A conservative investor would be interested in buying only at the lower end of that rational valuation zone, when the PEG is a lot lower than 1. He would further make a call depending on going interest rates to decide if the stock was worth buying at all.
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If the interest rate is low, paying a higher valuation for equity is reasonable. For example, if the interest rate is 5 per cent, a stock valued at PE20 is a reasonable investment (you invert the PE ratio to compare with the interest rate). At a going interest rate of 10 per cent or more, any stock with a double-digit PE must offer very compelling reasons to be bought at all.
Reflexivity defines the tendency for valuations (and prices) to overshoot the boundaries of rational valuation in both directions. If the stock is being sold down, the selling is unlikely to halt at exactly the bottom end of the rational valuation zone. It will probably fall much lower than fair value and of course, you want to buy when it is very under-valued.
Similarly, if a stock is richly valued in a bull market, it is unlikely to halt at the upper boundary of rational valuation zone. It might keep moving up till absurd levels. Again, you want to sell as close to the peak as possible.
Reflexivity occurs because of the herd instinct. Markets turn irrational because investors panic as group during bear markets and they all become euphoric during bull markets. If an investor is to reap the full return from any investment, he must allow for reflexivity.
Allowing for reflexivity means waiting for valuations to get irrational before you buy or sell, and it also means being prepared to leave some money on the table. A valuation-based strategy will never catch the absolute peak or bottom because the valuations will be very irrational at top and bottom.
On the upside, allowing for reflexivity is somewhat easier. You can set a “trailing stop loss” that is valuation-based. A trailing stop is moved up to trail behind the price as capital appreciation increases. Let's say that a stock you hold is moving up and you believe the valuation is rational until PE30.
You shouldn't sell if the PE rises higher than 30 as reflexivity kicks in. However, make a commitment to sell if it falls back till PE30 again. If the stock rises, move the stop loss up. If the stock hits PE35, move the stop to PE33. If it hits PE40, move the stop to PE 37. This way, if the stock peaks and falls, you book profits before the trend goes too violently South.
It requires much more discipline to buy, using reflexivity-based targets. If you think a stock in fair-value at PE15, you start buying below PE15. You must average down as it falls further. How low will reflexivity take it? You don't know. This is where holding your nerve and having faith in your judgement comes into play.