Staying short until you see a bottom can be used with trailing stop-losses.
The lag in Index of Industrial Production ( IIP) and Wholesale Price Index (WPI) data, makes them confirmatory, rather than lead, indicators. Taking the latest numbers at face-value, they confirm that Quantitative Easing II (Q2, 2011-12 will be lacklustre. This prognosis is backed up by recent statements from the Commerce Minister, lamenting that the demand for Indian exports is collapsing. Both domestic and external earnings growth could slow further.
This reinforces my belief that we’re entering the last, most destructive phase of the bear market that started in November 2010. If I’m right, the market will bottom in the next six months. That could be about 20-25 per cent down from current levels.
There are always several ways to play such situations. One is to stay short, until a definite bottom is diagnosed, or there is a sign of recovery. Another is to accumulate cash and buy safe businesses at attractive valuations. A third is to target stocks that look most vulnerable, first for shorts, and later, for long positions.
Any serious recovery will start with interest rates topping out, and the yield curve in government securities will also start to move back towards normal. Both are transparent signals. The RBI’s recent statements make it clear that the interest rate cycle is yet to top out.
As of early October, the 10-Year bond traded at 8.35 per cent while the 364-day T Bill was auctioned at 8.52 per cent and the 182-day was auctioned for 8.62 per cent. Yields are not only inverted; they are still rising.
The strategy of staying short until you see a bottom can be implemented with trailing stop losses. The targets may be the Nifty and BankNifty, or stock futures. The trader must be prepared to carryover short positions until and unless stop losses are hit. It helps to calculate correlations and cross-correlations of targeted stocks with the Nifty. Stick to indices unless you find high-beta “losers”.
The second method is the one sensible “long-only”, active investors will adopt: Keep cash in hand until valuations look better and then buy with a long-term perspective. This pays in the long-run. But it leaves a lot of money on the table while the bear market lasts.
With this method, you must average down, once you take positions. Again, benchmark and correlate any such portfolio with the Nifty. Don’t bother to take the time and trouble to pick stocks, unless you are confident the active method offers genuine prospects of beating passive index strategies. Hedging a long portfolio, via Nifty options, is reasonable. This strategy cannot be easily employed with stop losses.
The third method relies on something that is statistically reliable. In bear markets, many cyclical businesses, which are essentially sound, see massive slides in prices. Most of these bounce back strongly, when there’s a recovery. A trader who sells such stocks on the way down and buys again on the way up, usually beats the benchmark indices by large margins. But the risk exists of being stuck in stocks that don’t recover.
This is an extension of the “stay short” method. The judgement is delicate. You must find stocks that will lose more ground than the overall market and then, bounce higher. This usually means cyclical midcap businesses. There are a lot of liquid midcaps in the F&O segment and some will certainly go through this process of deep plunges, followed by sharp spikes.
As in every case where you are contemplating short positions, stop loss management is crucial. It is useful if you’re targeting midcaps to benchmark the stocks to both the Nifty (for hedging purposes) and also to some Midcaps index for tracking purposes. Hedging can be quite cumbersome in these circumstances, which may be a practical drawback, if you don’t like stop losses.
All three strategies involve fishing in troubled waters. Hedging, or trying to build in a safety factor by using stops, or a combination of both stops and hedges, is essential. This is neither difficult nor time-consuming.
A hedge via deep Nifty options will add a maximum of 1.5-2 per cent to the cost of a portfolio and it can be a life-saver if the market drops 20 per cent or more. A trailing stop loss essentially costs nothing. Just enter a memo on your phone to sell if a certain price is hit. Keep updating that stop if the price shifts in your favour.
It amazes me that investors who cheerfully spend three days calculating balance sheet ratios to the third decimal refuse to spend three minutes on this. There is probably a psychological barrier. It needs the trader/investor to accept that his view may sometimes be wrong.
