Exit Point

Why do all the trading literature concentrate so much on entering a trade? The successful exit strategy is as important as entry. And that would many a times make the difference between a profitable trade and an unprofitable one.

More on this later, when I finish some of the Technical Analysis books that I have got.

The Chase for Alpha

Much has been written and publicized by the investment managers about their ability to generate Alpha – above market returns. Most of the Mutual Funds offer documents and advertisements talk about how the fund has consistently beaten the market over the past years. And surprisingly, using very carefully chosen time frame as well as parameters, most of them have data also to substantiate their claims.

So, does it mean that these managers actually beat the market? Well, very unlikely – and if one adds the entry load (1-2% for most schemes), management fees (~2% annually), and exit loads (0-1%), there is very very miniscule chance that an investor would be better off by investing in a fund as against directly in the market index. Assuming an average all-expenses of 3% for a fund, you need the manager to beat the market by more than 3% to be actually able to generate alpha to his end clients. Add to it the fact that alpha is strictly a zero-sum game, and for every manager who beats the market, there would be another one who has been beaten by the market.

I’m strictly against use of Mutual Funds, atleast by people who can understand the basic nuances of stock market, and have the resources/skills to invest directly in the market. Most of the time we are afraid of losing money in the market – a fact compounded by frauds like Satyam, and we always run the fear that we may be caught on the wrong foot. However, the reality is that the same is true for a professional fund manager as well, and in fact I would like to think that they would have a larger tendency to take risks. And most of the fund managers in reality were caught napping during the Satyam fiasco.
So where does this leave an average retail investor? There are two choices for generating the market returns - (a) Using Index Futures, and (b) Using ETFs. I tend to prefer the latter over the former as futures are by their very nature a short term betting instrument, and if one plans to have an investment horizon of atleast an year, then futures would entail rolling the contract at every expiry – a costly as well as cumbersome exercise. ETFs are nothing but essentially a basket of all the stocks in an index, and have a small ticket size (currently INR 500 for Nifty BeES). Much goes behind the scenes with regard to how they are structured, and how they are able to track the Index. However, for a small investor, it would be sufficient to understand that they would tend to trade very close to the actual index value, and the management fees are much lower (0.50% or so) for these funds. So, if one just wants to have a plain exposure to the market, ETFs present a much better option compared with the mutual funds.

Why there is no word called ‘Bear-sh*t

To start with, let me put the disclaimer first:

I have a very strong belief that most of the asset classes in the world always trade at a premium over their fundamental value – defining fundamental value as what people would earn if they indeed keep the asset till perpetuity. I have a term for it as well – the ADR phenomenon. It goes like this – any ADR can anytime be converted into the underlying stock, and hence the value of an ADR will seldom fall below whatever an investor can earn by buying the ADR and then immediately converting that into stock. So, ADRs most of the time trade at a premium to the intrinsic price of the underlying share. The price of the stock here is the ‘Opportunity Value’ of the ADR – which could be derived any time the investor wants to. The same rational goes for the stocks or any other asset class – they always trade at a premium over what people can earn by holding them to perpetuity (their “Opportunity Value’). Only in times of deep recessions and market crashes do they trade below their values. So, more than 80%-90% of the times there is a bubble in the market.

Now building on my belief about the perpetual asset bubble in the world, any rational person would most of the time expect the market to correct (looking deeper into the terminology here – market falls are called ‘correction’, while the rise in markets are given terms like ‘bubbles’, ‘frenzy’, and ‘euphoria’). So, there is an inherent bias in the market where more people always believe that markets should fall. Whether they expect the fall to happen immediately or later is where the opinion differs, but they are all united in their belief that they are over-valued. There seems to be slight sophistication in thinking ‘Bearish’ – anyone who thinks markets would keep on rising is termed a naive retail speculator, whereas anyone who can substantiate a market fall is an ‘Economist’ or a ‘Trader’. So much are the professionals in the field biased against the bulls that they have named the ultimate description of crap as ‘Bull-sh*t’.

So, little wonder that all the ‘E’s and ‘T’s of the world are united in terming the latest rally as overdone, and are predicting another crash to happen ‘any moment’. No one likes a rising market – anyone can make money there. The dumbest of people end up making the most mullah in a bull market – as they don’t have the slightest of fear about a market fall. If one was born in US in the last 1970s, and discovered their senses in mid-1980s, then he/she saw was an ever rising market. How on earth would someone explain him/her that markets could fall as well. They were living in a ‘fool’s paradise’. NNT also warned against the bull markets, and bought deep OTM options – in the full knowledge that markets one day would fall big, and he would make a killing. He did make it, but that came after years of painfully watching the market move up, and seeing all his options expiring worthless (he did get all his money back, but that was from the sale of his books, rather than from the markets). No one ever loses everything in the market – either you make money, or you learn.

In the end, everyone is right about it – but seems that if you do not think about it too much, you are right on more occasions than the rational thinkers. You might lose everything you made in just one bad year, but then, its the same with the other side as well. So next time an expert warns you against a crash, just tell him that you would rather lose money in a couple of crashes, than being worried about it for all your life. And for all the ‘bears’ in the world, there is one simple answer - ‘Ignorance is Bliss’.

Are IPOs Underpriced?

In my B-School, I wanted to do a term paper on the Under-pricing of the IPOs. Sadly, the concerned professor had already been approached by many other students, and he rejected my application. And when I joined my job, the markets crashed within a short span, and IPOs almost dried up.

Now 2009 promises to be a good year for the IPOs, and I would expect at least 5 big offering to hit the market over the next few months. And I would really like to test the theory of under-pricing by actually subscribing to them. 

The first issue to hit the market is NHPC, and it has already opened. The price band is INR 30-36, and I would expect it to be over-subscribed by as much as 10 times at the least. Lets see how it performs!

Market Efficiency and Speculation

Much of the debate in recent few days has been about the massive amount of speculative positions in the stocks and other securities. People are blaming the short selling speculators for the demise of firms like Lehman Brothers, AIG, Bear Sterns, and many more. The argument is, even though the positions of these companies is sound in the long term, short sellers are putting undue pressure on the firms, and has resulted in forced liquidation.

I personally would think of these arguments as lame excuses. While not myself a supporter of naked short-selling to start with, I nonetheless believe that most of the firms which have fallen have fallen for the right reasons. If short-selling was to be blamed, and their balance sheet were sound, why would the senior debt holders in Lehman get only 8-9 cents per dollar as recovery? They ought to be making a lot more than this.

Short-selling didn't (or rather couldn't) have changed anything. At the low valuations at which Lehman Brothers or Bear Sterns was finally sold, the Management could easily have bought the firm with the personal pay-cheques. The fact that they themselves didn't do the same make the whole speculation argument seem hollow.

World Economy in Recession

I recently started working in an Investment Bank. And over the last one year, have had the opportunity to witness an event that may well describe our age. The credit-crisis have changed the shape of the world, and if not the Great Depression, this is at least comparable to the 9/11 attacks on the US.

Here are my learning from this recession:

1. Recession doesn't end very early, whatever be everyone's prediction about the state of the world markets, it does last for some time, sometimes for years. It may take us another 12 months to get to the end of the current one.

2. During recession, there are common themes which would always make money. One should be long the defensive sectors like FMCG, Pharmaceuticals, and be short the leveraged sectors like Real Estate, Banking, etc. Cash is king in these times, and sectors/companies with lower Debt/Equity ratios tend to outperform the rest.

3. At the onset of recession, rates usually move up - mostly caused by high levels of inflation. As recession deepens, central banks come into the picture, and start cutting rates. It might be a good idea to wait for rates to go up to 12-13% and then put some money into debt paper.

4. Oil and Gold perform very well during recessionary periods. One of the prime reason is flight to quality - these are commodities, and not paper certificates. Another reason is their link to inflation. Higher the inflation, higher the commodity prices. Hence, inevitably, most of the recessions are marked by rise in price of commodities.

5. Financial Sector is amongst the worst performers in a bad economy. The higher interest rates lead to de-leveraging, and lesser credit in the system. All this has negative effect of the banking system.

6. Big Caps always outperform the Small Caps, primarily because of the flight to quality syndrome. Another reason could be that during tightened credit conditions, small companies find it harder to raise debt, and their costs of funding soars higher.

7. Futures trade at lower premium (and even discounts) during Bear markets. This is simply due to huge shorting in index and stock futures by speculators as well as portfolio managers.

First Trade

In the last post I had mentioned about my first trade, and the losses I made in it. As it turned out, those were just paper losses, and I actually got to close the trade at a profit.

Whatever, in the end, I just got out capturing a panic-moment in the market when the stock went down from -4% to -7% in a few minutes. The best thing about the current market is that everyone is scared, and it takes only a few moments for a stock to fall down. The best policy during these volatile market should be to capture the intra-day volatility.

Still, the lesson is learnt from the trade. Next time, would be a little more careful before shorting a stock. It was a lucky escape for me, and I would be doing more home work from now onwards.

First Trading Lessons

As I write this, there is a major turmoil developing in the world markets. Bear Sterns is already down the dump, being almost acquired by JPMC for as little as USD 240 MM. Lehman has had a bumpy ride on the last two days. Yesterday, it was down by more than 40% at one point in time, and today, its up by 35% on the back of positive returns.

Anyways, as people debate over the future of the financial firms, and these wall street barons, I have put on my first real trade. I am short on ABCD stock and have hedged that by being long on the index. ABCD was down yesterday, and I had made a small profit yesterday. However, today, it went up and up, and I have more than 4% loss for the day. I would wind up this position at 5% loss.

First learning from the trading:

1. Never short a stock which is backed by a strong promoter having large holdings. The promoter can stand at a price, and even when the whole market is falling, the stock may just stand at one price.