Nifty 50 | Portfolio Yoga

Panicking is okay. Jumping out is not

We humans are prone to panic. Why else do you think we have so many horror movies that try to scare the shit out the viewers. In panic, we also do things that many a time can be regretful. We have seen more than once of people panicking and jumping out of buildings on fire. He survived the fire but died from the fall is rarely a good headline.

Today markets are on fire with Nifty down big time, something that was not seen post 2008. For any investor who entered the market in the last decade, this is akin to a building on fire where he feels trapped inside.

Everytime market falls, it’s generally because the world seems to be coming to an end and everytime one is disappointed that it isn’t so. Maybe, this time it’s different?

For the last few days, the US markets have been falling like a pack of cards. India not surprisingly is following suit for what the US does, we copy. Need more proof, check out this chart in a tweet I did a few days back

https://twitter.com/Prashanth_Krish/status/1234941743318982656

But the difference is that as recently as February, 80% of the stocks in US were trading above their 200 day EMA’s. Comparatively in India, we have been below 30 for a very long time (we briefly went above it recently just to get back to square one today).

This is my 3rd Bear market. The first bear market I experienced was the Dot Com bust of 2000 and while every fall is unique, the final outcome is similar – stocks get cheaper by the day till its so cheap that it starts to bounce back.

When we are suffering from a severe headache, the inclination is to remove the head to stop the pain. Thankfully, we cannot do that without killing oneself and the headache passes away in some time. It’s normal to feel similarly when it comes to our stocks and investments. The brain is screaming to cut out the source of pain, but cutting off other than letting you feel happy of having done something generally achieves the very opposite of what you aimed for when you started this journey.

Don’t be a Hero is being said of those who want to venture out to buy equities. Yet, these are the very people who in good days quote Buffett and the importance of buy and hold. Buying equity today is not about being a Hero.

Markets overreact all the time. In recent months, quality stocks were bid to the moon as markets wanted comfort in known names regardless of the price that was being paid. Today, some stocks are being sold at throw away prices because the same investor wants comfort and hold cash.

I have for nearly 5 years now been providing a simple asset allocation mix. On the whole, even the Aggressive model seems Conservative. But today when markets are falling like ninepins, this is what has given me comfort for I have enough dry powder that I can deploy more into equities and still be able to sleep well at night.

Diseases first kills people with pre-existing diseases and we are seeing the same when it comes to CoronaVirus as well. Bear markets such as the one we are currently in the middle of kills investors who are over-leveraged.

I bought a small bit of equity today and intend to add more in the coming week or so. But this is not a blind strategy speculating on a possible bounce in the near future. I have no clue of the coming weeks or months but if you were to talk about years, I am pretty certain that unless 90% of the world’s population dies, we shall have long past moved from this uncertainty.

If you have a cash flow and are comfortable with Risks, continuing to add is the right strategy. The very reason equities deliver a return higher than fixed in the long term is for taking such risks. If you are not comfortable with adding more risks, that is okay too. But do note, no opportunity comes with a blue sky scenario. Anytime you invest in equities, it’s a leap of faith.

Do note that any investments may not generate the returns you desire for the next one or even two years. Once you are comfortable with that, you can make your peace with whatever markets can throw at you including days like today.

The (in)ability to Act

There is a famous saying by Mike Tyson

Everybody has a plan until they get hit. Then, like a rat, they stop in fear and freeze.

As Investors, it’s easy to quote

Buy when there’s blood in the streets, even if the blood is your own.
Baron Rothschild

but as another famous quote goes

In theory there is no difference between theory and practice, while in practice there is

When we talk about markets, we generally refer to the large cap Index – Nifty 50 or Sensex as the indicator of how good or bad the markets are. While the Corona Virus has brought down markets around the world by a notch or two, the fact remains that this fall is nowhere if compared to earlier falls that have been seen by the Index.

Take a look at this historical draw-down from the peak chart. At just around 10%, this fall is nowhere in comparison with even the falls of 2012 or 2014 let alone historical falls. In a way, if history is any guide, this is the start and not the end of a correction.

But, Nifty 50 for a while has not been the correct way to measure market sentiments. While Nifty 50 was hitting new All time Highs, more than 70% of the stocks that are traded on the exchange were trading below their 200 day averages

To get a better sense of the market, I created an equal weighted index of all stocks. Do not that its equal weighted in price terms and not on the basis of market capitalization. The overall market seems to be down by around 14% with the bottom made in October 2019 being in a similar range of the draw-down that we saw in mid 2013.

Draw-down from Peak of Equal Weighted Market Index

Don’t catch a falling knife is another quote that is used during market downturns. Then again, if the final destination of the falling knife is your foot, that risk may be well worth taking.

I am a strong believer in buying momentum when it comes to stocks but playing contrarian when it comes to asset allocation. This means that you should be wary of adding money into equities when markets are rising and wary of withdrawing money from equities when markets are falling.

Having been in the markets since long, one observation I have been able to make is that while pre 2008, rarely did people refer to the crash of 2000 as something that could reoccur, despite the passage of 12 years from the time of 2008 crash, every fall is looked at as maybe the start of the next great melt down similar to what we saw in 2008.

Indian markets history is very small which makes it imperative to look at Dow Jones which has the longest running un-interrupted Index since 1896. Most of us have at max a 30 year period of Investing.

If you had started your investment journey in the US in 1902, at the end of 30 years, you would have been negative at the end as markets buckled down destroying years of hardwon growth. The low of 1932 was the same level as was seen in Dow Jones was in 1896.

An investor who invested in the depths of the great depression and let the investment grow for the next 30 years on the other hand gained a return that was not seen by investors until the investor of the 1970’s

End Result of a Buy & Hold of the Dow Jones . X Axis is the Investment Date, Y Axis represents the return for the same 30 years later

One of the toughest things when it comes to finance and investment is to be able to stand against crowd thinking. Right now the crowd is basically wondering if this is just the beginning of a bear market.

Purely going by the 200 day Moving Average as the line in sand between a bull market and a bear, we are in a bear market with all major indices now trading below. Then again, if you were to observe historical data, the 200 day average has been violated once too many.

A much more stabler and better alternative seems to be the 200 Weekly Average (approximately average of 4 Years). Here is a chart that plots the difference (in percentage terms) between the 200 Week Average of Nifty 50 and Nifty 50 itself.

Whenever blue has turned to red has generally tended to be a good time to invest but not every fall resulted in index dropping into the red zone. In fact, during 2004 when markets tumbled post the election defeat of NDA, even the unseen lows did not test the 200 DMA.

What this means is that if you wish to invest more into equities, waiting for the bottom may prove to be a wait in vain if markets take off without providing one such an opportunity. On the other hand, it’s always advisable to have some dry powder if such a situation emerges.

So, how do we deal with such a situation?

This is where Tactical Asset Allocation comes into play. Unlike traditional asset allocation where the view is to stick to a single allocation and relook at the same once a year or once in 2 years (or as a AMC head recently tweeted, once in 4 Years), the advantage tactical offers is the ability to move higher or lower depending on the situation at hand.

In Bull Markets, we are comfortable with a higher allocation to equity (even musing if we should have risked even more) while in Bear markets, we wonder why we are so high on Equity. The ability to act against the trend is neither simple nor easy and yet acting in line with the crowd while it offers ability to share the happiness in good times also means sharing of sorrow in bad times.

While being too early is as wrong as being too late, we all need to act at some or the other point and if you cannot, your returns will match your expectations or even market returns. Our inability to act during opportunities is because of the fear that we may be too early. Based on whatever data we have, I believe that is not the case. Yet, markets could fall more and hence going all in at the current juncture is not a good idea either.

Stagger your investment to predetermined levels based on either your own portfolio draw-down or the market and act on it. The other day I tweeted out saying that the worst case, I am expecting a 20% dip from here for the large cap and 30 to 40% for the Mid and Small Cap. But that may or may not happen.

Based on the above thesis of mine, my strategy is to stagger so that I can invest / move a part of my capital from Debt to Equity at every X% fall in my portfolio. If markets fall to my worst case scenario, I expect to reach the maximum allocation to equity I am comfortable with, else, I shall still continue to hold Debt higher than the lowest allowable level.

There will always be regrets, the question though is which regret is better to live with and which is not. No one is going to tell when the bottom is hit but having a plan (preferably written down) can go a long way in helping you act when the opportunity arises.

To Hedge or Not

When markets crack and they do crack all the time, it doesn’t really matter whether your portfolio is made of high quality stocks or low quality, your portfolio will take a hit. The only difference would be in percentage with high quality portfolio’s tumbling way less than low quality portfolios.

Derivatives were introduced to enable long term investors to take a hedge against short term corrections using options. But using options as a tool to protect portfolio from falls such as one we saw on Friday doesn’t come cheap.

Nifty 50 closed at 9965 on Friday. If one wanted to take a hedge, the best way would be to buy a At-The-Money (ATM) Put Option. A Put option, for those who don’t trade Derivatives, makes money when market falls. With October Futures traeding well above the 10K mark, the ATM option to buy would be the 10,000 Put.

Nifty 50 contract size is 75 and with the strike price at 10,000, this means a exposure of 7.5 Lakhs. In other words, if you have a portfolio that is totally correlated to Nifty 50, buying one contract of Nifty 50 should be enough for every 7.5 Lakhs of Portfolio Value.

But portfolios are rarely correlated to Nifty 50. While last week saw Indices dipping by 1.2%, the Median fall witnessed among Large Cap Funds (Direct) was 1.47% with the worst performer being Taurus Starshare Fund which fell 2.72%.

Nifty Midcap 100 Freefloat Index and Nifty Small Cap 100 Freefloat Index fell by 2.9% each. I would assume most investor portfolio’s fell by as much or more. This suggests that buying 1 Lot of Nifty 50 Put may not be actually enough to protect the downside.

The Nifty 50 10,000 Put of October closed at 135. One unit hence shall cost Rs.10,125. In other words, the cost of Insurance for a month will cost 1.35%. Not bad but then again, one needs to remember that most portfolio’s require more than 1 lot for every 7.5 lakhs of portfolio. At 2 lots, the cost now doubles to 2.70% – an amount that will disappear if Nifty closes anywhere above 10,000 on October 26, 2017

A better way to Hedge?

The risk of hedging using options is that by the time the market falls eventually, you may have run out of patience to keep buying puts and seeing them expire worthless.

A simpler and better way is to reduce exposure by way of Asset Allocation. While we all want to maximize when markets are going up, its tough to bear the pain when markets turn the other. This also means that when markets drop, you have cash to deploy rather than be part of the herd that pained by the enormity of the fall is waiting to just off load at any price.

Markets have changed dramatically since 2008. Any one looking into the past and hoping to invest when markets fall like they did in 2008 has been waiting for a very long time even as markets have gone one way up.

The chart above depicts draw-down from 52 wee highs that were seen in Nifty from 1995 to 2008. While we have more deeper corrections pre-2000 than post-2000, we did see some regular deep cuts. From 2003 – 2008, Indices rose 500% though we did have two cuts of 30% or more.

The same chart but now showing the 2009 – 2017 time frame. Not a single reaction of 30%, forget more. Comparing and Contrasting the two charts suggests that what earlier was 30% is now 20%, what was then 20%, now more of 10% and what was 10% now more of 5%.

Of course, this is no suggestion that we may not see a 50% or higher fall in the coming years – there is nothing like never again. But while probability of a fall of 50% or more is low, that is not the case when market tanks 10% or 20% from the peak.

We saw a 10% fall towards the end of 2016, a year which began with markets continuing to drop and finally bottom out 25% below the peak of 2015.

You asset allocation should take into account, the kind of loss you are willing to suffer if market crack 10% and yet have allocation that you can add more at that point as at the point when markets down 20% and later at 30%. I am using round figures though you are free to use any number you feel is place where you should start investing more.

The final objective needs to be that you are at the maximum exposure you are comfortable at the worst possible time. The negative of this strategy is that you will never be at the maximum for most of the times and that is okay if you understand the thought process is more about enabling you to stay through the journey.

To get a better understanding, here is a table that lists the draw-down in Nifty (from 52 Week Highs) using the Percentile method

What the above two data charts point out is the probability of market draw-downs > 40% from Year high of 52 Highs is pretty slim. Yes, we have had instances of market falling 50% or more, but as the above data shows, the amount of time markets spend there is less than 1%. This Analysis was conducted using data from 1990 to 2017. In 27 years, markets spent less than 14 week below such levels.

Waiting for the proverbial shoe to fall generally means that investors add more risk to their portfolio’s when they should actually be reducing and when that results in disappointment, reduce risk when one needs to add.

Reducing draw-down comes with a reduction in returns but what use are returns of the future if we cannot live through a draw-down? Food for thought?

Are we at a Tipping Point

The big read of the week has to be the “Howard Marks” Memo which these days seems to be the second most read fund manager report after the Oracle of Omaha. In this Memo, Howard warns about the Risks that the market seems to be ignoring as the fear of missing out (FOMO) seems to drive money towards ideas that in general times wouldn’t have been given a second thought.

Last weeek, I ran a Twitter poll asking if it was possible to see 20,000 on Nifty 50 by year 2020.

What probability would you give for Nifty to cross 20,000 by 2020?

— Prashanth (@Prashanth_Krish) July 21, 2017

Quite a few replied saying that they felt the chance was ZERO while the majority of voters felt that the chance was less than 25%.

The results weren’t surprising to me given that in recent times, there has been quite a concern that markets may have over-extended and it was time for a pull back. Yet, given the fact that we don’t know the future, should we write off even the remotest of possibilities?

No one really likes Bear Markets. While Value Investors claim to love Bear Markets as they provide them the opportunity to pick Dollars for Nickels, when the push comes to shove, I do wonder how many will be left standing let alone participate by buying stocks as they become cheap.

Bear markets come in different shapes and forms.

The 2000 Boom and Bust

Who doesn’t know about the Dot Com Bubble these days. December of 1998 was the start of the rally that took Nifty 50, a Index that wasn’t having any heavy weight Infotech Stocks at that time from 817 to a final high of 1818 in the space of just 15 months.

The rally in the Infotech Sector Index took quite a different route with the rally starting two years earlier in December 1996 with the Index floating around the 78 mark. When the peak was finally achieved, the Index was quoting at 9,550.

Similar to the Nasdaq 100 which took more than a decade to break its all time high of 2000, Nifty IT too broke its 2000 high only in 2013.

One thought process of where one should start a new bull rally emphasizes that a new bull rally starts only on breaking the previous all time high. Using that definition, we are still in the Infant stage of the bull rally in Infotech (validity to remain as long as it trades above the 2000 high) and yet IT stocks are a pretty hated lot.

Nifty 50 on the other hand took around 34 months before it broke above the 2000 high and 48 months it was before we were well and truly above that high water mark. Dow Jones Index on the other hand had to wait for 72 months before the 2000 high was broken only for the financial crisis to crater the Index well below even its 2002 low (Nifty 50 on the other hand didn’t really come anywhere close to the lows we saw in 2002).

Its another matter that the stocks of the next rally bore little resemblance to the stocks that mattered in the earlier rally.

The 2004 and 2006 Mini Bear Markets

Markets fell greater than 30% from their peaks in 2004 and 2006, but given the speed of recovery, this mini bear market is less talked about. While the trigger to the 2004 fall was the surprising end to the NDA government in which markets had great hope, the 2006 fall was triggered by global factors.

While both 2000 and 2008 are talked about as the great bear markets, 2004 and 2006 aren’t since the amount of time spent underwater was fairly short. Markets rebounded strongly from the lows and in no time were we back at the earlier peaks.

The Great Crash of 2008

Who needs to be told about the crash of 2008? These days, every time market starts to feel a bit too hot, the fall of 2008 is what comes to top of the mind. Investors who look at valuation seem to worry that every time we close in to the valuation we saw in 2008 prior to the fall, its just a matte of time before we see a repeat of the same.

At its peak, the much derided and yet the quickest way to figure out where the market lies, Nifty 50 PE was testing the highs it saw in 2000. Sensex PE Ratio (both of them being at that time of 4 Quarter Trailing Earnings on Standalone Balance Sheets) was a bit away from its peak of 2000.

Despite the difference in stocks (Nifty 50 has 51 stocks while Sensex has 30) and the weights, both most of the time top out simultaneously most of the times. 2008 was one such instance.

The fall of 2008 has for many who experienced the same has created a phobia of every fall being similar to the one seen in 2008. Seeing your retirement kitty (if invested in the market) fall by 50% or more is nothing some one can forget in a hurry.

For long, Foreign Institutional Investor have been the critical driver behind the rise and fall of markets. Other than for the one instance of 2016 where markets closed positive even as FII’s sold (Calendar year basis), every time, FII’s have sold, markets have dropped and vice versa.

Much has been said about how Mutual Funds are becoming the key driver in markets. But a cursory look at the Quarterly net flow of Equity Mutual Funds doesn’t really show it likewise. We have had similar inflow’s in 2007 for instance as we are having now.

The only difference is in terms of Gross Inflow / Outflows. While the first 6 months of 2007 saw a Gross inflow of 42,903 Crores , in 2017 its 1,24,517 Crores. This would suggest that while there has been a strong move towards Mutual Funds, the churn is pretty high as well.

Breadth Indicators

One way to determine where we are relative to earlier times is to look at a few breadth indicators.

Bull markets are born on pessimism, grown on skepticism, mature on optimism, and die on euphoria. The time of maximum pessimism is the best time to buy, and the time of maximum optimism is the best time to sell.”

John Templeton

A euphoric market is one when literally everything is flying. At this point of time, you don’t need to do any Analysis but just invest in anything that seems to be moving higher.

While Mid and Small Caps seems to have been in a Euphoric in recent times, the evidence doesn’t easily lend to that buzz. For instance, here is a chart which plots the percentage of stocks that are trading above their 200 day Moving Average.

The above chart contains 2 data points. The top pane plots Nifty along with the 10 day Moving Average of Number of Stocks trading above the 200 day Indicator. The idea of using a 10 day Average is to smooth out the volatility.

The lower pane provides the raw data – % of stocks trading in NSE that are above their 200 day averages.

At 60%, we aren’t really into territory that seems to be risky at the moment. In fact, post 2014 Election Rally, we haven’t seen the Indicator cross 70.

This in my opinion is indicative of the fact that markets aren’t totally over-bought. While one cannot rule out any reactions from current levels, any major bear market of the kind seen in 2000 or 2008 seems to be not on the cards unless there is a Global Meldown in Equity in which case, all bets will be off.

Valuation

The big elephant in the room would be Valuation. Markets are expensive based on PE Ratio regardless of what Index you apply the same upon. The only cheap Indices would be the Infotech and Pharma, but hey, who wants to invest there in the first place.

Above is the Nifty Price Earnings Chart over time with Average and Standard Deviations. A casual observation would be that while markets are expensive, they haven’t reached a point where the odds really aren’t in favor of exposure to equities.

Current market valuation is more expensive than in 2004 prior to the crash, but is the Index the same as what was in 2004? Currently Financial Services account for 35% of the total Index weight. This wasn’t the case in 2004 for instance when the composition of the Index was vastly different.

Only 25 stocks continue to be part of the Index when one compares the Index of 2004 to that of today. In other words, as much as its essential to look at historical data points to get a sense of valuation, ignoring the huge churn and differential weights can change the basic structure of the analysis.

HDFC Bank for example is trading at 30 times its earnings and is closing onto representing nearly 10% of the Index weight. A High PE + High Weight in turn would pull up the overall weight of the Index. Is HDFC Bank cheap or expensive is another story altogether.

The path forward

Wouldn’t it be lovely to have a Almanac which can give us precise turning points of the future (Experts of GANN, a style of Technical Analysis would love to claim they know such dates) so that we can be fully invested when markets are trending higher and be totally in cash when the trend turns to bearish.

While we cannot project the future, one thing that is bound to showcase the future as it happens is the chart. Right now, the market is strongly bullish regardless of what method you apply. At some point markets would start to roll over breaking major supports and trend-lines on the way. That would be a better time to become bearish than try to predict the top based on tools that fit our narratives.

Above chart is as on date. Compare this with similar chart of the previous bull run. See something similar?

Is the chart of 2017 similar to one of 2008 or are we placed similar to 2006 or 2004? Once in a while markets can go up sharply at a 45 Degree Angle. While they mostly end up correcting, not all corrections end up like 2008.

I for one continue to believe that the best way to play would be to follow a Asset Allocation mix that is suitable under current circumstances and one while allows us to reach our goals even if the best laid out plans falls flat.

Buy the New High

At the very heart of Trend following is the concept of buying at new high with the assumption being that market knows something that we don’t. While the logic works on literally all time frames and tickers, some are better suited than others. Indices for example are better suited than even its Individual components, Commodities better than the End Users among others.

In bull markets such as the one we are currently in, every day you see a large list of stocks that are hitting new highs and vice versa when the markets are bearish. The chart below plots the sum of All stocks that hit new 52 week highs subtracted by All stocks that hit 52 week lows. As you can see, its been bullish (though not overly we we saw in 2014) for quite some time now.

Buying at a new high is tough mentally speaking. After all, you have witnessed a rally (that you may or may not have participated in) and its normal to wonder whether one is too late to enter. Nifty 50 for example is 26% above its 52 week low which got posted just a few months ago (29th Feb 2016). The question hence is, after missing out of that 26% move, does it make sense to commit now especially when analysts are calling the market as being highly over-valued and primed to fall.

Spreading fear is easy in markets, after all, markets do tend to move higher at a very slow pace but fall precipitously when we hit a speed breaker. Nifty 50 hit its first 52 week high (based on look back of 240 days) after having previously hit a 52 Week low on 25th July 2016. So, lets take a look at what history says has happened when Nifty 50 hit its first 52 Week High.

The above table is a list of dates when Nifty 50 hit a new 52 week high and what happened later on. The last column showcases the returns between when it hit its first 52 week high and the return at the time when it hit a new 52 week low. Even ignoring that, what the table above suggests is that save for 1997, markets have provided positive returns in the days and months ahead.

Lets also look at the same table but when markets hit a new (first time) 52 week low.

Surprise, Surprise. Buying the new 52 week low isn’t as bad (if you could have withstood the draw-down) as it sounds in theory. But as with anything else, we have a problem and the problem is that there isn’t really sufficient data to draw conclusions we want to draw upon. Yes, we are using around 20 years of data, but our data points are too few to provide us with a realistic view.

Given that we are wanting to test our theory, there is no better way than to use the same logic on the Dow Jones Index which has around 120 years of data to back it up. What is the outcome if we test the same concept there.

First, lets start with data of what happened when Dow hit a new 52 week high.

And now, the same when Dow hit a new 52 week low.

Unlike the data of Nifty 50, here with more data we can easily see why it makes more sense to buy a 52 week high than buying a 52 week low.

On 4th June of this year, I wrote a blog post titled “Start of a New Bull Market?” where I showcased why I felt this was maybe a start of a new bull run. As on date, we are up around 6% and I do feel we have some distance to go before we crash. But then again, no one knows the future and the only way to go is to work with probabilities and know all the exit doors in case the trend doesn’t go as we anticipate it will.

Share this:

Share this:

A better way to Hedge?

Share this:

The 2000 Boom and Bust

The 2004 and 2006 Mini Bear Markets

The Great Crash of 2008

Breadth Indicators

Valuation

The path forward

Share this:

Share this: