Wednesday, November 7, 2012

How to benefit from market cycles when investing in the stock market

Stock markets around the world follow cycles, just like business cycles. As investors it is vital we understand this fact and invest accordingly. In general there are "Presidential cycles" (yes! It is a well-accepted term in the US), Elliot waves and Kondrateiv cycles. In basic, cycles do exist and many scholars and experts have come up with different research.

A cycle consists of a period of growth, a peak, a period of decline and the bottom. A "cycle period" is the duration between two peaks or two bottoms. The ideal scenario in investing would be to invest when the market is at a bottom and sell out when the market is at a peak.
Charts illustrating a cycle can be viewed by contacting your broker or by making use various equity market analyzing software. It is empirical that investors are informed of such cycles as it helps them to "time" their investments in such a manner to make a profit.
During the rally (i.e. the growth stage and peak) the investing general public will liquidate other assets and buy stocks. Some people will go to the extent of leveraging their portfolio to harness further profits. These were the characteristics of our market during the 2009-2011 Bull Run. During the downtrend, the investing public sold their stocks fearing that stocks would fall further and built up a bad image about the stock market. However, what we have failed to recognize is that these events happen in every market around the globe. Even in the most developed markets. This is merely a cycle and without doubt we will be seeing more of this in the future.
The investing general public is mostly engaged in other professions. Therefore, most investors rely on their stockbroker to make decisions for them. By having an understanding of cycles, investors can make buy/sell decisions themselves that will help them to make gains without taking unnecessary risks.
Below are some statistics compiled from data from the CSE All-Share Price index (ASPI).
Average gain/ (drop)
Period – months
Bull market
Bear market
On average during a bull run, the CSE All-Share Price index (ASPI) rises by 176% from the past data that has been compiled. During a rally, the market can correct itself and this period normally lasts for 5 months. During a bear market the ASPI drops by 38% and lasts for 30 months on average. These statistics do show that markets are very volatile and that investors should be informed of it.
In Sri Lanka, a cycle lasts 6.3 years on average. We are currently at the bottom stage of the cycle. This means that stocks are priced at relatively cheaper prices and have potential to rise in the mid-term. Basically, stocks take 46 months to reach a peak. As rational investors, we can assume that on average we need to hold a stock for 46 months to book the maximum gain. Therefore, investing in the stock market is a timely activity but its returns are unmatched!
However, the most important fact we have to remember is that a downtrend in the market is always followed by a rally. 
During the 2009-2011 Bull Run in the CSE, foreign funds were net sellers with Rs. 46.4Bn! That just shows how foreign funds have timed there selling correctly and that they exited with phenomenal gains. The simple rule they followed was that they bought into Sri Lankan equities when local investors were selling and sold them back to us when we were buying with a "herd instinct" during the bull run.
In the current bearish period, foreign funds have invested approximately Rs. 34Bn net of outflows. We are seeing the cliché of investing wisely. It is inevitable that these funds will exit the market during the next Bull Run with massive gains. We as Sri Lankans should be more careful when following the herd during boom days. Instead of buying when everybody is buying, we should be keen to invest when everybody is selling.
"Look at market fluctuations as your friend rather than your enemy. Profit from folly rather than participate in it" – Warren Buffet.
The US in the 20th century has faced two world wars, many other expensive wars, the Great Depression, plenty of recessions, oil shocks, flu epidemic and many more adverse events. However, the Dow Jones index has risen from 66 to 11,497. We may not see such a rapid expansion in the US going forward, but emerging countries such as Sri Lanka definitely has the potential.
Currently in Sri Lanka we are seeing a steady rise in interest rates. This hampers investments into equities and as a result the ASPI is falling. Interest rates and equities have an inverse relationship. A reversal trend is where we see that the Central Bank lowers its policy rates and intends to decrease it steadily in the future. Upon this reversal trend we will see that investors will find equities more promising. Hence, a large influx of funds will flow into the stock market. This is where it is ideal to book profits for investors who had bought during the downtrend.
From the above graph, the most recent rally was from early 2009 to early 2011. Since then we see a bearish trend. However, a reversal was seen in September 2012 but we are currently seeing bearish trend again. The idea is to build up an understanding of the behaviour of the stock market by analysing the cycles that it goes through.
A stock market rally will always be followed by a dip and a bearish trend will always be followed by a rally.
An example of how a well-established foreign fund benefitted from the stock market cycle of 2007-2011 is explained below:
As we have all seen, the end of the civil war sparked off the previous monumental rally from May 2009. The foreign fund in the meantime had built up a stake in listed firm "Tokyo Cement PLC's" non-voting shares. According to the quarterly reports filed at the Colombo Stock Exchange as at 31st March 2009, the reputed foreign fund had over 51 million shares amounting to 57.2% of the outstanding non-voting shares. It was naturally the largest holder of the company's non-voting shares at this point. The closing price for the period was Rs. 9.00 whilst the lowest price was Rs. 7.75.
Once the Bull Run kicked off at the CSE with cessation of the civil war, the foreign fund has steadily decreased its shares in the market. However an important note should be made that when Raj Rajaratnam who was an important investor during the period was charged in the USA for insider trading, the market saw a period of decline. At this stage the foreign fund had bought back some shares it sold at lower prices. This event just shows how the foreign fund benefitted even from a period of correction!
Thereafter, the fund had slowly sold down its shareholding whilst most local investors were grabbing shares in a buying spree. By December 2011, the foreign fund did not even appear in the "top 20 shareholder list"…
During 2011, the ASPI touched an all-time high but steadily declined thereafter triggering the period of bearish activity. By that time, the price of Tokyo Cement non-voting had touched an all-time high of Rs. 55.00 and traded regularly in the Rs. 35.00 - 50.00 price range.
This is a classic example of how investing should be done. No unnecessary risk, just buying when the market is low and selling when the market is high.
Foreign funds will always study our potential before investing. They will follow rigorous research and studies to complement their decision to invest. These funds saw the potential of our economy during the sluggish years before 2009 and we are seeing it again this year with a monumental Rs. 34 billion net inflow. We would not be seeing such a large net inflow if the world outside of Sri Lanka didn't believe we still possess tremendous potential. As Sri Lankans, we should do better to gain from our own stock market!
This article was written by Abhishek Kalupathirana of  Lanka Securities (Pvt) Ltd, with auspices of the Research Committee of Colombo Stock Brokers Association

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