nifty | Portfolio Yoga

An Update on the Markets and what to Expect

The following is part of a note written to subscribers. Sharing the same here

It would not be an understatement to say this week was a tumultuous one for mid and small cap portfolios. While a small correction is not really something one should be worried about, the fact that the correction is coming after months of rise should make us pause and take a deeper look.

As I wrote in the Monthly Newsletter last week, our performance has been inline with the performance of the small-cap universe since the start of this rally in April 2020. Since the low in March 2020, Nifty Small Cap 250 has delivered a return of around 200% vs returns of 110% for the large cap universe.

This outperformance came with barely there volatility. But if history is any guide, this is going to change.

One of the philosophies followed by Technical Analysts is Elliott Wave Analysis. This theory posits that markets move about in waves. Bull markets are divided into 5 waves while bear markets are divided into 3.

The theory has its faults but in the broader sense it actually showcases how Fear and Greed combined with economic cycles are seen in markets. While pure ellioticians use the strategy to try and predict to a precise level where the index shall go, I use it to get an understanding of where we are in a cycle and how the future could unfold.

The Wave 1 of a new cycle is always sharp, mostly surprising and one that sees investors mostly itching to get out versus getting in. If we were to take the move from the lows of March 2020 to today, it fulfills the first couple of requirements. The strong move up was a surprise to the best of the analysts tracking the markets.

Let’s look at what to me are a couple of Wave 1 in action in the past. Do note that these may not match the purists who are more detailed, but my objective here is not to try and find where the markets shall end at but provide a context to the move and what we can expect in the forthcoming weeks / months.

The bust of the Dot Com bubble brought Nifty down 55% from the peak. While the Vaypayee led NDA government was in power, for the markets, it may well have been the Deve Gowda period – a period of absolute lacklusterness and low activity.

Starting in May 2003, the markets took off in a way that was reminiscent of the dot com bubble but was more broader than the previous avatar. From the low of 920, Nifty went up to cross the 2000 mark before the correction started.

The correction in itself was deep owing to the surprise fall of the NDA government with Nifty at the worst point being down 36% from the highs. The move up in the Indian markets wasn’t really independent. The S&P 500 Index too started to move from Mid March 2003 before topping out in February 2004.

While the Indian Markets saw a deep correction owing to local factors, S&P 500 went more or less sideways though the direction was on the upside.

The more recent move that can be categorized as Wave 1 in my view would be the one which started in March 2009. Was this as unlikely as that of 2003? You bet it was. The world was supposedly coming to an end and there was little that anyone could do.

From the low’s of 2009, Nifty Small Cap 250 rose by 235% over a period of nearly 1.9 years. To give a context, Nifty Small Cap 250 has risen by 223%.

2011 was a year of correction with Nifty dipping 30% from the highs while the Nifty Small Cap 250 dipped 45%.

Corrections are important for they ensure that valuations which tend to go way high during bull markets get smoothened out in either time or price based corrections and from every evidence we have, we could be at the start of one such correction.

The breadth of the markets continues to remain strong. That is not surprising since no broad indices have even breached the 10% draw-down from the high water point. While Nifty 50 has made a new all time high even today, since mid February 2021, Nifty has been flat – what we call as a time based correction and is up just around 7% while Nifty Small Cap 250 is up 30%.

This divergence is not sustainable and shall generally get closed out. But these could stretch too. The chart below plots the route differential between the Nifty 50 and Nifty Small Cap 150.

While the end result is the same, the path they took has been different.

Now let’s look at a time frame when the Small Cap for a while did better than Nifty 50, the correction in the Small Cap indices brought the returns to the same levels as Nifty 50 by mid 2018.

Now let’s look at the same comparison but much more recent

Most Momentum Multicap Portfolio’s tend to underperform when the broader markets are underperforming. We saw this between 2018 to around mid 2020 before the strong move from mid 2020 has more or less made Momentum the most chased strategy by retail investors today.

There is no easy way out. One way would be to shift from a multi-cap portfolio to a large cap portfolio. This will reduce the risk though if Nifty crashes, there is no avoiding the same. While even the Momentum strategy will move to more of a Large Cap over time, past experience has been that draw-downs should be expected.

Another way to reduce risk would be to cut down on the exposure to the markets. Asset Allocation is a wonderful way to reduce risk. But there is a trade-off. If the market continues to rise further, the pain of not participating fully can come back to haunt one to the extent that one makes mistakes at the first sign of opportunity.

Nifty continues to hit all time highs and the breadth remains extremely good. While wobbles such as the one we saw this week may suggest that we are closer to a top, it could also be an intermediate stop.

Overall Corporate Earnings have come at either expectations or have done better. This bodes well for the market in the short to medium term. The risk though as Barry Ritoltz emphasized in his blog could come from a resurgence of Corona in the US. He wrote,

If we do not radically improve our Vax rates ASAP, the entire economic recovery and precariously positioned, somewhat expensive market is put at risk of a 20-30% crash. This one will not have the trillion-dollar stimulus and rapid recovery of the 2020 edition, but rather, will be long, slow, and painful.
Ritholtz

This is not to say that the markets will react. The data for now suggests that it may continue to move higher. But the moves in the broader market is starting make one wary. Could be a false positive in which case, mea culpa in advance.

June 2021 Newsletter – The Fear of a Crash

“Far more money has been lost by investors trying to anticipate corrections, than lost in the corrections themselves.”
Peter Lynch

The biggest question most people seem to have about markets today is not if a correction is going to happen but when. The list of reasons seems to keep growing. The US housing market for instance is posting the largest annual gains since 1980.

Both in India and the United States, Retail Investors are jumping into the action like never before. Millions of new accounts are giving a boost to the bottom lines of brokers. Look at the spike in trading numbers at Angel Broking, a discount broker.

While investors who have seen multiple cycles are exercising caution, the plethora of new investors whose only historical understanding is – Buying on Dip is the easiest way to make money is in the frontline of activity.

One of the biggest winners in the last year has been Saregama. Saregama has moved from 180 which was the low of March to 3480. Incidentally Saregama was a big winner in the Dot Com boom too, moving from a low of 12 in March 1998 to a high of 2310 in March 2000. Sometimes history doesn’t just rhyme but actually repeats.

Some disconcerting charts from the US Markets

I am not a great believer in surveys and yet this showcases how one sided market participants may have become in this rally.

Previous chart seems to go perfectly well with this chart. Buy Right and Sit Tight – who does that anyways.

Since April 2020, Nifty Small Cap 250 Index has seen a negative month just twice and even there, it was not greater than 2%. The index itself has risen 210%. This is a phenomenal return that we have not seen in the Index in such a short span of time.

Year to date on the National Stock Exchange, we have had 199 stocks that are below where they were at the beginning of the year and 1441 stocks that have gained. The average gain being 61% vs average loss of 14%.

When markets move too much too fast, it only brings bad memories to those who have seen a bear market or two. Is this the end one starts to question. This more so when one sees stocks that have been dead being rescued more by narratives than numbers.

Near the peak of the dot com bubble, we had an Initial Public Offer by a company called (I hope memory serves me right here) Computer Shoppee. The company was a new one and hoped to set up computer shops throughout the country. What was interesting about the issue was that the issue was at a face value of Rupee One. I don’t even remember if it was listed since the bubble burst soon after.

The Public Offer of Reliance Power which has become folklore. Cut to today and we will shortly see public issues by companies that have over time lost tons of money and even today have no clue about when it will eventually turn profitable.

One way to look at if markets are closer to a peak is to look at the percentage of stocks that have generated high returns in the last 3 to 5 years. The thought process here is that at peaks, most stocks would have gained tremendously. This is also a reason for the public to get attracted because it shows them that making money in markets is fairly easy.

The above graph denotes the percentage of stocks (Y Axis) that had the gains in the bracket. So, for example at the peak of 2008, 35% of stocks listed on the National Stock Exchange had 5 Year CAGR returns between 25% to 50%. Today this number stands at 26%, similar to what we saw at the end of 2017.

Since February of this year, we are seeing divergence in performance between the Large cap Index and the Small Cap Indices, This again foretells of a high probability of reversal on the cards though how long a divergence can remain is anyone’s guess.

While there are enough and more reasons to be bullish on India today, the fact remains that like Siamese twins joined at the hip, we are joined at the hip with behavior being dependent on how the markets of the United States behave.

Just take a look at the 10 year comparison between Dow Jones (in USD) and Nifty 50 (in INR). Where is the Modi magic one may wonder.

In 2008, India did not have a housing crisis or were its Banks in any sort of trouble. Earnings growth was strong and the future outlook remained strongly bullish. We even had a word for the short term divergence our markets saw with respect to US markets – decoupling.

The United States was not the first country to go for massive quantitative easing. That was Japan. Will the US go the Japan way as many bears seem to suggest? In the recent past I have been trying to read more about the macroeconomic situation in Japan both pre and post the fall and my guess is that the risk of the United States going that way is fairly low.

The Japanese tend to feel shame and disgrace upon a failure such as a bankruptcy. In the United States, bankruptcy is just a way to clean out the slate and start afresh. The ideological difference cannot be more stark.

While cheap money does lead to bubbles – the dot com bubble for instance is blamed upon the easy money policies instituted by the Federal Reserve post the 1987 crash, bubbles aren’t a one year phenomenon either.

For a while now, I have been strongly bullish on the markets and continue to believe in the same. Having said that, drawdowns are one of the ways markets tend to shed off excess weights. Here is a chart that plots the maximum drawdown seen every year since 1996

A 30% drawdown was a pretty normal occurrence in the markets pre-2008. Post 2008, it’s become a rare species. Drawdowns to me are opportunities.

How many days does it take the market to recover and move to a new high. The above chart tries to denote that. The year is when the markets hit a new high and the time spent (trading days) in the drawdown.

The recent experience in a fast recovery from a significant drawdown is not really rare. 1994 saw markets touch a new high just 2 years after the scam had broken out and the Index had plummeted more than 50% from the peaks.

Not everything is bad though. Writing in Economic Times, Aashish Somiah writes,

Nifty earnings grew by 14% in FY21, at its fastest pace in 10 years.

Also, in contrast to the trend of downgrades seen over the last few years, FY22 and FY23 earnings estimates continued to remain steady. In fact, if realised, the FY22 earnings growth estimates of 35% as per sell-side consensus would be its highest since FY04.

I look at market breadth for they tell the story way better than what is told by the large cap indices. Across the board, markets are bullish. This is as true for Large Caps as for Micro Caps. The divergence is building up.

In early 2008, the number of stocks that were hitting new 52 week / all time highs dried up even as the indices were kissing all time highs of their own. No such divergence this time around.

There is no real play book that provides a way to play out the current scenario. Advisers generally prefer caution and advice reducing exposure as a way to limit the risks. The trade off is that if markets continue to gain, the opportunity cost could be fairly high.

A secondary way to reduce equity exposure would be to wait for the market to begin its downward march before reducing exposure. The trade off is that one cannot exit at the peak but close to 20% away from it. The advantage being that one can stay until the music has been turned off.

Of course, historically the best way has been to stick with the system and the markets come rain or shine. But we all know that, ain’t we. You don’t need to read a 1300+ word drabble to know that the best returns are those who don’t try to time every aspect of investing.

I captured this image from a video on SpaceX but I think it closely resembles the actions of majority of investors. Wonder who can the Pied Piper of Investors in India.

Trend Following is Dead, Long Live Trend Following

2020 was an awesome year for trend following traders. They made money when the market went down in March and made money when the markets rebounded for the rest of the year. 2021 on the other hand seems like a year (and one that is not even half done) and I am pretty sure most clients have either quit or close to quitting the strategy that seems to see no end to whips.

I used to be a systematic trend follower (and a discretionary trend follower earlier) for a while before I realized that this game was not for me. The reason is not that I did not have a good system to begin with – in the long run every trend following systems generates returns that are slightly lower than the underlying on which it trades but with a much reduced risk (risk being measured through draw-downs).

If markets have a risk of 50% draw-down, the idea here is to try and limit the damage to say 25% so as to allow 2 times leverage (or 3 if you are iron hearted) and which allows for the absolute outperformance of the underlying. For example – assume you have a system that will generate 1000 points on Nifty vs say 1200 points Nifty would have generated for a buy and hold investor. But the buy and hold investor would also go through a pain of a 50% drop in value at some point of time.

If you are a Buy and Hold investor and try to leverage on Nifty at just 2 times, once you hit the 50% drawdown (in reality it will be even earlier), your capital is fully destroyed. But if your system which generates a lower return than Buy and Hold also has a max draw-down risk (in theory again since we can never know the reality until it strikes us on our heads) of say 25%, you can safely leverage 2 times or even 3 and yet not fully lose your capital at the worst possible times.

Like Momentum Investing which is hot today because its out-performing the other alternative strategies (are we really I wonder sometimes but that is a question for another time), last year one could see the launch or rocketing up of many trend following strategies built on Nifty.

Way back in 2012, my Job was to Build / Test and Implement trend following strategies on proprietary money. Very soon after we went through a very tough phase of non trending markets (rather the Index). It was tough and yet we came out alive.

The reason we came out alive had less to do with the system (though I am sure helped in a way) but more importantly because we were diversified across multiple Indices and Stocks. While the Index itself was choppy, this was not the case with a few of the stocks and those cushioned our draw-down quite a bit.

Like in Investing, Diversification can save the day for many traders. But there is a problem and that is Capital (not to mention Time). A long while back, I had written a rudimentary post on how much capital would be required (Capital Requirement for a trader).

Since then though, experience (both personal and of others) has taught me that I was very conservative. I think if you really want to be a successful trend follower today, I believe that the capital requirement would come to a Crore of Rupees.

The reason for the high capital is not for the ability to withstand draw-downs but ability to deploy it in multiple Indices / Stocks / Currencies / Commodities. Stocks have a very strong correlation with Index but Currencies and Commodities don’t for most part. By having a broad portfolio of underlying to trade with, you reduce the risk of getting whipped out of one’s capital because one bad underlying one has set out to trade.

A large capital also allows you to trade multiple strategies which further add value (think of trading both a short term trend following vs a long term trend following system for example). But more the strategies and more the underlying on which to trade is not easily possible without a team that can support such an operation or automation.

Trend Following has a very low correlation and hence is an attractive strategy that one can add to one’s arsenal. But it comes with its own caveats and limitations which one should be fully aware of. If you cannot afford a large capital (1 Crore at the minimum), the attractiveness of the strategy goes down faster than the option decay you see on the expiry day.

PS: The featured image is of the Equity Curve of Dunn Capital. Look at the pain (draw-downs) that have been felt over time (Image Source: Trend Following Performance: Huge Returns).

The much awaited “Correction”?

Some weeks are good, some aren’t. But for the markets since November, every week was a good week if not a great week. Rare have been the times when we saw such exuberance in markets with everything flying off.

Making money never felt so easy. All you had to do is be long in a stock, in any stock for that matter. Of course, this exuberance wasn’t limited to Indian Markets alone. US markets which we track closely seemed to be doing the same as the countdown to the end of President Trump started.

With Biden taking Oath, on twitter it would seem as if the United States has been freed from a dictator. Happy days are here again it seems or maybe not for there are very few men (or women) who have had no faults.

Markets dislike consensus. If everyone loves a stock too much, the probability is high that the stock will either do nothing for a while or worse retrace a part or the whole of the journey it had in recent times.

Too much good news is bad news. Between Biden taking the floor, the CoronaVirus vaccine being out and the Federal Reserve promise of unlimited bounties in the near future, there doesn’t seem to be much for things to go wrong. Complacency sets in and just when you think that the Sun will finally set in the east will the market surprise one like none other.

Fund Managers are bullish. I am bullish. In fact, other than a few friends many of whom I know are always skeptical, I cannot find many souls who aren’t bullish in this market. Then again, why would you want to be bearish when you can be bullish and reap in the rewards.

From its low of March, Sensex has doubled. But if you were to move your starting point back to the start of 2020, the gain would have been just around 20%. Nothing out of the ordinary.

In the past, one was used to seeing a decent pullback when the market deviated too much from its mean in too short a period of time. The crisis of 2008 changed all that and we are now used to seeing shallower and shallower corrections. The correction of March 2020 was in fact the worst correction we have seen since 2008.

Corrections are good and welcome. A friend of mine asked why I was hoping for a correction when I would not short the market. A correction will be painful for my Bank Account since I have no intention to exit the market at the first signs of a retracement but at the same time, markets that keep moving higher without a correction are like a forest which keeps accumulating dry wood. A single spark is enough to cause worse damage than limited fires over time would have.

When it becomes too easy to make money, investors lose proportion of what is risky and what’s not. In the bond markets for instance today Greece and Spain which have never really recovered from the crisis of 2008 are able to borrow cheaply than even countries like India despite our cleaner record of repayment and a more stable currency and economy.

My belief that I have been forming in the last few months is that we are at the start of a multi-leg bull market. But a bull market doesn’t mean a one way move without any corrections. During the 2003 to 2008 bull market which was one of India’s finest and best bull markets of all time, we faced 2 corrections of greater than 30% and 2 corrections of 15%.

A correction in the Sensex to say around 40,000 may seem extreme today but 40,000 was what we broke above as recently as November. Like in games, markets need a time-out once in a while to enable everyone to catch their breath. As investors, we should welcome such moves.

As I write this, India VIX is around 22.88 which means that traders aren’t really expecting a huge crash. But things can change on the dime.

“Luck Is What Happens When Preparation Meets Opportunity” – Seneca

Nifty and Bear Markets

Whenever market corrects, one fears it may be the start of yet another bear market and this fear is largely due to historical experiences of those bear markets which literally took investors and even traders to the washers. A bear market is depressing in more days than one since its said that the pain of a loss is always greater than the happiness of a win and a bear market is one such painful process.

The general definition of a bear market is of either a 20% drop from the top or the break of the 200 day Moving Average. But these definitions suffer from fact that even deep corrections are mislabeled as a bear market when its actually just markets being a bit more volatile than normal.

Another definition of a bear market which seems to adjust for corrections comes from Ned Davis Research, a firm that is able to crunch and plot data in ways one did not even thought is possible. Their definition is that a market is considered as having entered a bear phase if it is down greater than 13% after 145 days from day of last high. 145 trading days equates to around 6 months of calendar days.

Based on above definition and taking data from 1990 on wards, Nifty 50 has seen 9 Bear Markets with 10 being underway currently. Below is the table that lists the same

How to read the above table

Start -> Start of this leg (Day after the last new High)

Max D/D -> Maximum Drawdown seen in the fall

Max Date -> Date of the Maximum Drawdown

Days to Max -> Trading days it took to go from 0 to Max D/D

Days to NH – > Days it took for the D/D to travel from 0 (previous high) to 0 (New High)

Peak-and-Trough Analysis on Nifty 50

A adage in the market says that Stocks take an escalator up, and an elevator down and in this environment with Nifty falling like nine pins day in and day out, one actually wonders if it has taken the elevator or has actually fallen through the elevator shaft.

While till recently the mood of the market wasn’t bearish, the last time we saw a new high was way back on 3rd March and a month from now, we would have passed a year without being any closer to the same (unless of course the market decides to make up for all the mistakes in double time and make a new high before that).

But, historically what has been the duration of time spent between two highs and more importantly in light of the fact that we are now down 18.75% from the high point, what is the average draw-down one encounters.

When markets are hitting new highs, there is generally some amount of continuation and to avoid small number bias, I have reduced the number of highs to those that occur at least 1 month after a previous high. In other words, if markets hit a new high 3 times in the month, I ignore the 2nd and 3rd high and take for my calculation only the first.

But to calculate the draw-down and number of days spent, I use the 3rd high so as to ensure that only the draw down seen after the last high to the next high gets measured.

This time its no different

So, we have had one more day of Blood letting with markets showing no signs of bottoming out even though domestic institutional investors continue to Buy into the weakness, a weakness that has been caused majorly by global factors accompanied by ceaseless selling by foreign institutional investors.

Blood letting was a medical practise carried out as late as end of the 18th Century due to the belief that only by removing all blood could some of the ailments be resolved. The reason is survived so long was due to the faulty way its success and failure was calculated. If the patient survived, the blood letting worked whereas if the patient died, the catch was that the patient could not be saved even though blood was let. A kind of Heads I win, Tails you lose.

In the markets, blood letting is a ritual that is practiced every year. Investors who are strong survive to see another year while weak Investors just die never to come back again and will be replaced by a new breed of investors hoping to make a mark.

Markets are now down 18.43% from its peak but for many a investor, it seems as if the floor has given way. This could be due to the fact that the markets which topped out in early 2015 has been on a consistent decline ever since. Of course, this was not visible in the Mid and Small cap segments which till a few days ago were in a world of their own, but the flight of capital from Small Caps where the exit door is very small has made it similar to people trying to rush out of a single door when a room full of partying people suddenly realized there was a raging fire outside.

But the draw-down in itself has not been abnormal. Nifty has seen a average decline of 21.87% (even if you remove 2008 from the calculation) from the year high and in that aspect, the current draw down for 2016 is just 6.60%.

Every fall is a opportunity provided one is ready to catch the same when its available. In panics, investors (both retail and institutional) are so immersed in trying to get out that they are willing to sell Gold for a few trinkets of Copper only if they can get ready access to cash. We are no way closer to that though a final long term bottom would see something similar. Hope you are ready when that happens.

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Some disconcerting charts from the US Markets

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