Monday, June 30, 2008

How low can the Sensex go?

That must be the question on the lips of every investor.

Inflation is going up, so are interest rates for borrowings. Pretty soon banks will be forced to raise interests for fixed deposits. Oil prices are at an all time high. The political situation is in turmoil with the Congress and the Left fighting harder than the bulls and bears!

So the fundamentals – at least in the near term – are looking bleak. That tells you the Sensex will go down further – but can’t tell you how far. Score one more point for the technical analysts over the fundamentalists.

Enter Fibonacci retracement levels. For some strange reason better known to smarter investors than me, the Sensex tends to reverse direction at levels of 38.2%, 50% and 61.8% of its previous move (up or down). Of these, the 61.8% appears to be the most significant.

If we take the entire 5 years bull run from 2900 in 2003 to 21200 in 2008, we had a total up move of (21200 – 2900 =) 18300 points. The respective Fibonacci retracements are:

(a) 38.2% of 18300 = 7000 points

(b) 50% of 18300 = 9150 points

(c) 61.8% of 18300 = 11300 points

So the retracement levels are:

(a) 21200 – 7000 = 14200

(b) 21200 – 9150 = 12050

(c) 21200 – 11300 = 9900

The 14000 level has been violated already. So the next stop is at 12000. If there is no retracement at 12000, then the Sensex can drop to 10000. (Now you know why these numbers are being talked about in the media!)

If the 10000 mark is violated also, then the Sensex may retrace the entire up move. This is a possibility but highly unlikely considering the current growth path of the Indian economy.

Let us, therefore, concentrate on the 12000 and 10000 levels. We seem to be in the grip of an 8 years time cycle. In 1992 and 2000 we had bear markets where the Sensex retraced between 50-60% of the up moves. As we are in the middle of a bear market again in 2008, my guess is that history will tend to repeat itself. (In 2004 and 2006 we had bull market corrections – but the long term up trend line was not broken; it has been broken conclusively in 2008.)

Chances are that the Sensex bottom will be somewhere between the 11000 and 12000 levels, and there will be some consolidation at that level before the market begins to turn back up again.

If you are a pessimist, wait for clear market up trend signals before entering. You may have to wait till the end of the year to do so. If you are an optimist, start nibbling at fundamentally strong ‘A’ group stocks once the 13000 level is broken.

Monday, June 23, 2008

Why Michael Ballack is a good role model for the better investor

There are two kinds of people in this world - those who are crazy about soccer and those who aren't.

For the latter, who are missing some of the most exciting midnight entertainment of sudden-death penalty shootouts and stunning extra-time goals, Michael Ballack is an outstanding German midfielder with a rocket right foot (and the Austrian team will vouch for that!).

So what does Ballack have to do with investments? It's his left foot (not to be confused with Daniel Day Lewis' Oscar winning performance), with which he can kick the soccer ball just as hard and with immense power.

Which brings us to the unresolved debate about fundamentalists (pun intended) and technical analysts. Fundamentalists don't understand technicals; technical analysts believe that all fundamentals are reflected in the price!

Just as an international soccer star needs to use both his feet, the better investor needs to learn about the fundamental analysis of companies as well as study the technicals of price charts. Why?

Fundamental analysis looks at an industry, whether it is a sunrise or a sunset one, and then identifies companies within that industry, their growth rates, future plans, profitability, management quality, competitive advantages.

After doing all that hard work for a particular industry - let us say for infrastructure, you make a short list of three companies: DLF, L&T and BHEL. All supposedly great companies. If you had bought them in December 2007, you are losing 50% of your investment.

Technical analysis of individual price charts or the Sensex (or Nifty) in December 2007 would have indicated a severely overbought status indicating an imminent fall. Exactly the time when you should not buy.

More on this debate in future posts - so stay tuned!

Tuesday, June 17, 2008

Now, become a better investor by reading the ‘scriptures’

If you are a student of the Hindu religion, then the three most important references will probably be the Bhagavad Gita, the Vedas and the Upanishads. But if you are studying Comparative religion, then you may also refer to the Quran, the Bible and the Talmud.

To become a better investor, study the following ‘scriptures’:

  1. One Up on Wall Street by Peter Lynch
  2. The Intelligent Investor by Benjamin Graham
  3. Common Stocks and Uncommon Profits by Philip Fisher
  4. The Five Rules for Successful Stock Investing by Pat Dorsey

Lynch’s book is the easiest read but contains all the guidelines for ‘fundamental analysis’ of companies. Graham’s book is an all-time classic, though a tougher read. Fisher’s book was used for the longest time as a text at Stanford University’s Graduate School of Business.

Dorsey has written a very practical book that uses real-life examples to explain fundamental concepts, and emphasizes the importance of the cash-flow statement to study the financial health of companies.

I think it was Lynch who humorously denigrated ‘technical analysis’ as “a science of wiggles”. Some of the books I found useful in understanding technical concepts are:

  1. Technical Analysis Explained by Martin Pring
  2. Timing the Market by Arnold and Rahfeldt (of Weiss Research)
  3. It’s when you Sell that Counts by Donald Cassidy

The saint Sri Ramakrishna Paramhansa had demonstrated that there are many ways and different religious beliefs that can be followed to attain the common goal of Nirvana. In a future post, I will discuss why both fundamental and technical analysis should be followed to attain the common goal of becoming a better investor.

How to lose more money and become a better investor

You may be among the unfortunate many who got caught up in the buzz of the Sensex hitting 20000, and jumped in to the market in January 2008. That means you are sitting on substantial losses. Even if you had entered in January 2007, you are probably making losses.

This is just the time for you to turn your ‘paper’ losses into ‘cash’ losses. Which means actually selling the shares in which you are losing money instead of holding on to them. Why would you do such a 'foolish' thing?

Because you never know how low the market can go, and when it will rise again. (The previous bear market from 2000 top to 2003 low lasted three years. This one has only completed 5 months.)

If you bought a share at Rs 100, and it falls to Rs 50, you lose 50%. But if you hold on expecting to sell when the stock reaches 100 again, you are expecting a 100% rise in the stock price. Not impossible but highly unlikely.

If the stock falls further to Rs 33, your loss is 67% but to get back your original Rs 100, the stock has to rise 200%! (Do not use this 'opportunity' to buy more. Your average price may go down, but your losses will keep increasing.)

A better investor will quickly learn the concept of a 'stop loss' - a price below which (s)he will 'book' losses and get out. Setting a stop loss is an art, and will depend on your risk taking ability and your conviction in the quality of the stock.

For example, if you have bought Tata Steel at Rs 900, you can set the stop loss at 30% and not sell unless it falls below Rs 630. But if you have invested in Ugar Sugar, then the stop loss should not be more than 10%.

So you decide to take my advice and 'book' your losses. Now what to do with the money? Do NOT, repeat DO NOT, put it back in the market right away. Put it in a short term fixed deposit or a Liquid Mutual Fund, and watch how low the Sensex goes.

Chances are it will test its previous low around 14700 and go even further down to 12000 levels - if oil prices and inflation continue to remain unfavourable.

In the meantime, do not sit idle. Buy some books and start doing your homework. The next post will discuss a few books that I have found helpful.

Sunday, June 1, 2008

How to lose money and become a better investor

This is the first of a series that I plan to post to help dummies like me become better investors in stocks and mutual funds. If you like reading it, my effort will be rewarded; if you don't, please let me know why so I can improve. I am assuming that you are not as complete a dummy as I was when I first started investing ;)

One of the oft-quoted myths of investments goes like this:

Rule number 1: Do not lose money
Rule number 2: Read rule number 1

Such great advice is totally inappropriate for dummies like me. It is almost like saying "Do not fall down" when learning to ride a bicycle. Just like you will fall down a few times before you learn to ride a cycle, you have to lose some money before you learn to invest in stocks.

In fact, losing money is an essential part of becoming a better investor. Now this goes against the grain of logic. (I will elaborate on this in my next post. I expect that will be next Sunday.)

When you begin making your initial foray into investments, chances are you will not have too much cash in hand. So going to an investment advisor wouldn't make much sense. You will end up going to a relative or a friend - whom you consider to be an expert - and ask for tips or ideas.

Despite best intentions of all concerned, the first couple of investments will probably go sour. Even if the investments actually generate a profit on paper, you may not be able to take that profit home because you will not know when to sell!

If you are a dummy like me, you will enter the market near the top - when all the excitement and buzz is at its peak. Pretty soon the market will drop and you will be left holding your investments - not knowing what to do. If the market drops further, you will get into a panic and call your friend or relative for advice.

Guess what the advice will be? "Hold on a little longer; the market will rise again - sell then." The market will rise but not to the level at which you entered. You will sell at a small loss, relieved that you avoided a bigger one.

A timid investor will run away from the market after such an experience and put the money in a bank - where inflation will eat away a major chunk. A dummy like me will decide to buy some books and learn more about the subject. And he will already be on the road to become a better investor.

(In a future post, I will list out a few books that dummies like me can understand and use.)