Predicting equity markets is not possible. Well, more than not possible, it is not necessary. Should we try it, at all or is it just a waste of effort and time. Well I can argue both ways, and for 99% of the investors, trying to guess the market direction and speed is completely unnecessary. However, there are a few people who try to create their own portfolios, for them this post could be useful. This is just one of the prevailing ways of thinking. As always, I do not always use this, but it is something which I have found useful in a bull run or a bear run, and of course, I have gone wrong too.

Let us say the Sensex continues to hit new all-time highs. The technical readers, the press, etc. keep telling you, this is bullish. We are also  told, that new highs are typically followed by more new highs! True indeed, at least until the last new high is reached; that last new high or “the” top is, well, bearish. The tough part, is in sorting out the many minor tops from “the” top. Most of us may have tried and many failed over the past few years and after the unrelenting advance say in 2003 to 2007, nearly all of the Bears capitulated.

Rather than trying to predict “the” top, you are much better trying to spot the top curve or the top few points. This is tough, but your process should be a continual assessment of underlying conditions. You should be attempting to answer : are conditions currently supporting an expansionary or a slowing down environment? For us in India, there is also an urgent need to answer ‘will the FII stay or go away to better opportunities in other parts of the world including the USA? You are not seeking certainty (in a price discovery market, certainty cannot exist). You are merely evaluating the probability of various outcomes. While that’s not exciting, it is the best that you can do, and anybody telling you otherwise is bluffing.

Research shows that the probability of weakness within the equity market is higher when certain slowing down conditions are prevailing. Almost all of us who are handling only our own portfolios, are running ‘absolute return portfolios’ – if we can shift to bonds or cash in such conditions, we should. This is of course a defensive position, but makes senses. Let us take the case of a single share (I am not a full market as a barometer for prediction). When LnT, Tata Power, Cholamandalam, Kotak, Hdfc, Bhel, Siemens – were running havoc in 2007 with PEs at astronomical levels, I sold. The indicator? PE. None of them deserved that kind of a PE – and the defensives were JUST NOT GOING UP. How many of you have seen the prices of FMCG in the so called ‘2003-7’ boom? They just did not move. Sure, on an average, bonds tend to outperform stocks during such periods. I did not move into bonds, instead I moved to cash, some fmcg, etc.

Currently what are the indicators in the market? I am not clear, but at Rs. 1250, Cholamandalam was at a very good ripe price to sell. Wait a minute, were there any ‘NEW’ sell signals? NO. Absolutely not. The share was over priced at 900 as much as it was at 1250. So as a pure Quant driven portfolio, Chola would have been sold out long ago. I sold a very very small quantity at 1240 knowing that I would buy it back at 1140, if it were to hit that price (I was happy to let go that position too without regrets if it went to 1300). I did get an opportunity to buy back at 1100, and I did buy. I immediately sold at 1130 or something and am waiting to buy. I do get a lot of trading opportunities in Chola, Coro, etc. but not so much in Hdfc Ltd and Hdfc bank – the price discovery in those scrips is far superior, there is no arbitrage opportunity!

Now, does this mean that every time I go to cash / defensive I am predicting a top or “the” top? No. Not always. It JUST indicates that risk in the equity market is rising, AND you will not lose much by NOT BUYING this share at this price. Sure in shares like Asian Paints and Hdfc bank, you need to be far more nimble and have very strict stop loss, or deal with a fraction of the shares. So if you have say 50,000 shares of a company and are willing to play, play in small lots of 500 shares. So if I am confident that Chola is fully priced at 1240, I should sell some shares and sell MORE at 1300 and Rs. 1400 if all this were to happen in a short time. However, the pitch can be queered by great results in one quarter – FORCING the market to re-rate the PE. Then you need to prepare for the new normal. There will be times when our signal to rotate into cash is wrong and the equities continue to advance. In such cases knowing whether the whole market is bullish, whether the industry is running ahead of its time, and your risk and portfolio weight appetite will all come into play. What does one do if the share keeps going down – say from 1250 to 800? should you cover?

Well, then we come into ‘relative valuation’. Exactly when Chola has come to 800 has something else come down too? Is there some other better opportunity? In the industry or in another industry? Should one use that money to buy Equitas? Spice Jet? Cummins? How is one to allocate CASH back to equities? Well you need to think afresh. Choose the best opportunity at that price – and that may not be Chola. So you took market indicators – like FMCG strength or weakness to take a decision on an NBFC, and now you may be directing it to Infra or Telecom or Realty. Remember when you are managing your own money, YOU ARE RUNNING YOUR OWN absolute return fund, so think like an ARF and not like the CIO or CEO of a fund house. They are here to make money for their shareholders (oops right, shareholders, unit holders are the route).

Caveat: I may be having a long, short, or FnO position in any strategy, and this writing is for informational purposes only and does not constitute an offer to sell, a solicitation to buy, or a recommendation regarding any securities transaction, or as an offer to provide advisory or other services.