Be wary of bull market traps

A decade ago, many investors had entered a rising market and lost significant wealth

Ten years ago, when the BSE exchange’s Sensitive Index, or Sensex, was fast closing in on 20,000 points, Rahul Agrawal, 40-year-old entrepreneur and regular investor in the stock market, took a personal loan of Rs 10 lakh and bought select stocks. He even tried his hand at futures trading. About a year later, the value had been reduced to less than Rs 1 lakh.
 
 “The drop was so fast that I could not get out. Though the market recovered in the following year (2009), it took a long time for me to make some money on the investment. Meanwhile, I kept paying an equated monthly instalment on the loan. I doubt if I have made any money even now,” Agrawal says. No wonder, he has decided to sit tight although the Sensex has hit 30,000 points. “I won’t put in fresh money till I feel comfortable,” he says.
 
In the calendar year 2007, the Sensex rose 47 per cent to close at 20,287 points. A year later, it fell 52 per cent to 9,647 points. During the year, it even fell to  8,535 points after the Lehman crisis in September 2008.
 
For the stock market investors, there is a lesson. While the US markets had started falling from October 2007 due to the sub-prime crisis, the Sensex kept going up. Market analysts and many television anchors kept telling Indian investors that there was a decoupling between the Indian and US markets. Many investors blindly went and invested money. In  three months, Indian markets cracked and it hurt investors badly. 

 
Ten years later, we are at 30,000 and going strong. And the bull analysts are back to predicting new highs for the benchmark indices. “Whenever stock markets surpass their previous peaks, the commentaries from experts change to justify the expensive valuations. New concepts are floated to tell investors it’s different this time,” says Arun Kejriwal of Kejriwal Research & Investment Services. An investor can easily fall for such advice as they appear logical. But it is always better to stick with your strategy that has worked. If you unable to take a decision, don’t do anything.
 
Suddenly, valuations don’t matter: Analysts find reason after reason to justify the sharp rise in a stock or a sector. The most common one: Earnings will catch up. For example: With the government incentivising affordable housing, a whole lot of analysts have turned bullish on realty companies, housing finance companies and companies manufacturing cement, paints, sanitary ware and so on. The rationale: If the government has a target of constructing 10 million houses within three years, the companies supplying raw material should do well. These homes would be bought on loans and, therefore, housing finance companies have a huge opportunity. The reasoning is logical but we forget there are significant inventories in several cities which are unsold. The builders need to get rid to these as well and the bad news, given that there are job cuts happening in sectors like information technology, there is little confidence amid potential buyers. While buying a stock, take into account these factors.
 
Fast forward earnings: To further validate the investment idea, analysts say the stock might look expensive but future earnings justify the price. The most commonly used valuation matrix is price/earnings-to-growth (PEG) ratio. This is a good tool to measure a company’s expected growth. The problem is that many use two-year or three-year forward earnings while calculating it, to justify the high valuations. According to a recent report from Kotak Institutional Equities, there is an earnings downgrade risk in financial year 2018-19 due to higher than the estimated loan-loss provision in banking sector, weaker-than-expected commodity prices and stronger-than-expected exchange rate.
 
Tips galore: Whenever markets are going up, there are emails, SMS and even calls from brokerages, some even fraudulent, inviting you to invest in the next ‘multi-bagger’. More often than not, these stocks will not be known names. As the joke goes, in the 90s when the information technology boom was happening, simply adding ‘Infotech’  to a company’s name could change its fortunes. Many investors burnt their fingers badly by investing in such unknown companies.
 
Good companies, but how good? Few companies have consistently grown their business at a compounded annual growth rate of over 20 per cent. These companies, in the banking sector and in the discretionary consumer spending segment, usually trade at higher valuations than peers. You will hear analysts recommending these stocks with the reasoning that an investor needs to pay a premium for high-growth companies as there is a lot of money chasing few high-quality company stocks.
 
While paying a premium is justified in such cases, the question is how much an investor should be willing to pay. “You look at the growth potential of the business, say three years or five years hence, then discount it and see if makes investment sense. An investor should also be willing to hold the stock for three to five years,” says Mahesh Patil, co-chief investment officer, Birla Sun Life Mutual Fund.
 
Whenever foreign institutional investors (FIIs) pour money in the domestic markets, it sees a sharp rise and vice versa. Due to the growth in systematic investment plans in mutual funds (around Rs 4,500 crore a month) by individual investors, domestic institutions are also flush with funds. Many point out that the new highs are being made because of excessive money chasing stocks, and this would continue.
 
Sanjeev Prasad, senior executive director and co-head (strategy), Kotak Institutional Equities, wrote in a report: “If investors are making active decisions, they should also be deciding the fair value of stocks based on fundamental factors and not on liquidity. A key question to ask is whether liquidity changes the fundamental value of a stock through changes to earnings or cost of equity.”
 
Where the markets would head from here is uncertain. “A 5-10 per cent downside cannot be protected, as markets don’t move in a linear direction. To protect investments from any major correction, we are keeping a balanced portfolio,” says Patil of Birla Sun Life MF, who is staying away from cyclicals and is keeping six-seven per cent in cash.
 
PPFAS Asset Management has also increased cash and equivalent in its fund. Rajeev Thakkar, chief investment officer, PPFAS Mutual Fund, explains: “Currently, we are in a strong momentum market, especially in the small and mid-cap space. There are some investment managers who see the present as a new era for the country and for them the size of the opportunities justifies any valuation. We are not in that camp. While we recognise the potential, we continue to be anchored by valuation parameters.”