Four reasons why sharply rising markets aren’t a good thing

At a glance

Rising markets bring cheer all round – However, there are potential downsides to rapid upmoves – An investor should be aware of the potential downsides in such a market – A perception of loss in investing momentum due to fewer suitable stocks – Bias for action manifesting itself in ill-advised buys or worse, sells – self-serving advisers pushing myriad products – the false confidence of a thanksgiving turkey


 

Missing the “good old” days

This time last year, I was happy with my investing routine. Markets were languishing, inflation and deficits of all kinds (fiscal, monetary, trade) were overarching issues sapping the growth out of the India story. Experts were shunning “rate-sensitive” sectors and “defensives” were the thing to buy. As blue-chip defensives traded at 40 times earnings, my online brokerage was executing monthly orders for defined amounts into a set of decidedly un-sexy stocks.

Come May 2014, all that changed overnight. Suddenly, you couldn’t have too much of capital goods, consumer durables, power etc in your portfolio. Apparently “acche din” were on their way. With stock prices resembling the flight path of satellite launch vehicles, I pulled the plug on first one then other SIP stock purchases. I referred to this steep rise in two of my recent posts, ‘Election fever and deciding when to buy‘ and ‘Markets this quarter and a game of dominoes‘.

The problem with having spent some time in the market and having read a bit of Graham, Damodaran et al is that fast-rising markets make me uneasy. Because they mean four things:

1. Fewer good buys

The one and only thing in the control of the investor is what you agree to pay for a stock. So for the calm investor, frothy markets mean fewer opportunities to buy good companies at reasonable prices. But “thumb twiddling” as a strategy sounds far less convincing than any that involves frenetic activity. Hard enough to do on it’s own but made worse by it’s side-effect, I.M.F. Syndrome

2a. Itchy mouse-click finger syndrome – Part 1

The siren call to any calm investor: “So what if the core set of stocks you believe in have run up, here’s a set of stocks that still haven’t as much. Buy!”

The bias for action is strongest when the bull market is young and every market observer is crying themselves hoarse about the beginning of the multi-year secular bull-run where stocks can only go one way, UP! Even for the most unflappable investor, this leads to justifying expensive stock buys with some or other cockamamie rationale. Measures ranging from Price-to-Earnings to Price-to-Potential-CashFlow-When-planets-align are touted as reasons why it would be madness to not buy them at current bargain prices

2b. Itchy mouse-click finger syndrome – Part 2

Or call it “throwing the baby out with the bathwater”, or simply, Selling. Our in-built aversion to taking any kind of loss means we avoid selling losers. The other side of loss aversion makes us keen to sell winners. To make the notional gain real. After all, what if the stock falls and I “lose” all that gain I could have made? And when is this tendency most likely to make an appearance, but in markets that are making new highs…

Combine #2 and #3 and you have the perfect recipe for accelerated impoverishment.

3. Dawn of the planet of the fakes

The obvious easy-to-spot ones, like the accompanying image are just part of the story. Rising markets bring all kinds of them out of the woodwork. They range from the benign like your friendly neighbourhood bank relationship manager (RM) suggesting well-known mutual funds to your brokerage customer service manager whatsapping you new fund offer (NFO) details to the downright toxic scam “hot tips” about micro-cap stocks you’ve never heard of. It’s when offers of buying stocks “on just 15% margin” start arriving at your doorstep that you know the rally might be overdone.

Just like it’s harder to delay gratification when it’s 3am, you’re drunk and the nearest open joint serves a mean double cheeseburger, it’s harder to steer clear of random advice when the initial euphoria of a smart rise in your portfolio wears off and you look for the next big kick.

 

4. Hubris

Turkey Problem_thumbIn his book Antifragile, N Taleb refers to this as “the turkey problem“. Simply put, the confidence that turkeys on a farm have about their longevity is highest after weeks of being fed and cared for, and just before thanksgiving weekend when things change, abruptly, bringing life-expectancy (and weight) down to zero.

Being right makes an investor feel good. It increases confidence about his own ability to make the right calls. In rising markets, this spills over into over-confidence and a sense of infallibility. Funnily the extent by which the self-image of investing ability exceeds actual ability is at it’s maximum right before the correction that sends returns reverting to the mean.

 Just like it’s easier to pick undervalued stocks in a depressed market, it gets harder to find reasonable value in a rising market. Add to that questionable advisers and the specific ways a buoyant market distorts our perception of what is, in fact, a good buy and the ways and means of undoing a disciplined method are numerous.  That’s why an investor needs to be particularly diligent about what he chooses to do or not do in a rising market

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