April 14, 2017

The Hangover from bull markets

A lot of people are celebrating these days and patting themselves on the back. We have a parade of investors touting their returns and claiming that 100% CAGR is for chumps. Multi-bagger could soon be a new name for kids :)

A bull market feels good and should be the best of times, right? How can one argue with that?
It feels great when your stocks are going up, making you richer by the day. You feel smart, on top of the world and in some moments can even see that retirement on the horizon when you stop working and live on the beach < insert additional fantasy as needed>

By my own estimates, I have lived through around 4 major and a couple more minor bull runs. It felt great during those periods as I  felt vindicated for sticking it out during the drops when everyone was rushing to the exits. It is only in hindsight, I have realized that bull market are dangerous in their own way and I was lucky to have survived the full cycle.
Let me explain

A confluence of factors
A typical bull market usually coincides with decent economic numbers when most companies are doing quite well. As a result, most participants become over optimistic and bid up the stocks of these companies. We thus have a confluence of factors – companies performing better than usual and being valued at higher multiples of peak earnings.

In addition to these factors, there are several psychological factors which come into play at this time. Let’s go over some of them
-           Social proof: At such times, you see people around you getting rich and more reckless the person, higher the returns. It is not easy on the psyche to watch your friends get rich , whereas you sit around doing nothing.
-           Scarcity: During bear markets, waiting helps. As the numbers are bad or getting worse, stock price for most companies stay stagnant at best. As a result, if you like to dig deep into a company, you have all the time in the world. No such luck during bull market. Any company with a half decent results gets bid up. As a result, you can either forgo an opportunity or buy the stock with lesser due diligence
-           Confirmation bias: A bull market gives a positive signal and makes you feel that you are doing something right. As a result, there is a tendency to ignore risks and not look for disconfirming evidence
-           Authority bias: If you switch on a channel, every other talking head and self-proclaimed guru on  TV is painting the vision of a glorious future where all of us would be rich. This makes you feel as the only idiot who does not get it

In effect there are multiple psychological and other factors, which conspire to get your guard down and ignore the risks
A bad hangover

I can recall the emotional roller coaster in the previous cycle, with the only difference that these cycles used to run over a period of 3-5 years. The years 2001-2003 (which is ancient for most investors) was a grinding and slow bear market.

It was the exact opposite of what we see now. I can remember buying companies selling for 5 times earnings, growing at 15-20% per annum and still going down in price. If you think these were low quality stocks, then that was not the case. I am talking of companies like Marico and pidilite which are the darlings of the quality school of investing now.
A new investor like me just could not understand why the market was behaving in this fashion.

The market started turning in 2003 and from there it took off for the next 5 years. A lot of my personal holdings went up multiple times (no one used the term multi-baggers as often then) and it was great to feel vindicated/ smart.

The problem with feeling smart was that is that you also feel invincible. The net impact of all these emotions is that I made a few picks, which were marginal at best.  These sub-par picks came back to bite me during the next downturn when they performed far worse than the overall markets.
A fight against instincts

The natural instinct for any investor is do the opposite of what should rationally be done.  When the markets are dropping due to poor fundamentals and bad sentiments, the tendency of most investors is to withdraw into a shell and wait for the sky to clear up.

This is usually the wrong action. Unless you believe that the world is going to end (in which case, stocks should not be your worry), it makes sense to buy attractively priced companies as markets usually have a tendency to extrapolate the recent trends into the future.
The same tendency is also visible during bull markets which leads investors to buy at the wrong price. The right action at such times would be to sell or do nothing, if the company is not overpriced. I personally think that one should go one step beyond – use this period to clean up your portfolio. If you hold some companies, which you are not as confident about, sell them down and increase the cash holding. A bull market is a good time to  swallow the bitter pill when the overall portfolio is doing well.

It is never easy
I wrote this a year back after the market dropped by 15% and this still holds true, except the circumstances have changed to a bull market.  Instead of courage to manage the fear, one needs the same courage to manage greed and euphoria.

It requires an equal amount of effort (or even more) to watch everyone around you make easy money, while you stick to your principles and refuse to take part in the madness.

Stocks discussed in this post are for educational purpose only and not recommendations to buy or sell. Please contact a certified investment adviser for your investment decisions. Please read disclaimer towards the end of blog.


Lucky said...

Rohit, you are completely missing the point!

We have a great PM who has got us the GST and is pursuing the black money with demonetization and IT / ED raids. India ranks better in terms of ease of doing business. In fact, the government has gone so far as defining a new mechanism for calculating the GDP. We can expect an 8+% growth rate for decades to come and "achchhe din" for the man on the (Dalal) street. Stocks always do well in the long run and no valuations are high enough when the country has such a long runway ahead. THIS TIME IT IS TRULY DIFFERENT.

Only that the more things change the more they remain the same! Whether or not all of this translates into anything meaningful has not been considered. Of course, no questioning of the valuations is acceptable because nobody would want to spoil the party! You just need to follow the online forums to realize how happy some people are and how jealous their friends are. So expect the frenzy to continue.

And then one day, there will be a tiny-winy event causing a small-time sell-off and suddenly people would like to protect their gains. And the rest would be history...

Dheeraj Dadhich said...

Nice read sir !

Rajesh said...

Your point is valid Rohit. The market have moved up a lot in recent months. Even I was deliberating few weeks back on whether on invest more at current levels or not. If I look at various factors, like political stability in India(at least next 7 years), Recent measures taken to reform the economics as well as politics(to certain extent) of the country, lack of similar growth opportunities in other countries etc etc... I do not find a reason to let loose my portfolio or stop looking for further buying. But I agree that it becomes difficult to find the right stocks at right valuations in these markets, specially for the value investors. So one has to step up his /her risk quotient and determine which stocks to invest in.

I would still be a buyer in the market, but without letting myself too loose on the yardsticks for stock picking. Emotions should be kept aside.