How to spot a potential bubble

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“It’s not supposed to be easy. Anyone who finds it easy is stupid ”- Charlie Munger After setting the context for this article, let’s start with a simple definition of a“ bubble ”.

Bubbles occur when assets become artificially expensive, driven by a misconception known as a misconception.

There are identifiers that could help us spot potential and irrational exuberance in the market. Here are seven:

Entry of new investors

About 1.42 crore in new mat accounts were added in FY21, roughly three times more than that seen in FY20.

The average age of new investors tends to decrease and the mix is ​​skewed towards level 2 and 3 locations. This indicates that new investors with limited experience are entering the market. Most of them have only experienced a one-way ascent in the past 15 months. In the short term, the market is like a pendulum: we need to observe the behavior of new investors during a downturn to understand the sustainability of retailer participation.

Leverage the game

Customers are ready to put on more weight to enjoy the rally. (Leverage refers to the act of borrowing money to speculate in the market; this is usually funded by the broker or an NBFC). Most of the brokerage firm’s margin funding portfolio has doubled in the past year.

Leverage is a double-edged sword. In good times, leverage amplifies return and during a downturn, which is usually unavoidable, it takes away a lot of capital earned when the market was rising.

Unless used wisely, leverage does more harm than good to investors, especially if they approach investments as speculators and not as long-term investors.

High risk appetite

Raising money without difficulty is one of the biggest signs of market sentiment, as investor risk appetite is very high at this stage.

Investors are prepared to allocate more capital than they otherwise would, to asset classes that have performed extremely well in recent times.

The record raising by new funds, the gray market premium (GMP) and the subscription to large IPOs (bids exceeding 100 times the amount of the bid) bear witness to this sentiment.

Large IPOs

Another sign of a potential bubble is that large IPOs are starting to hit the market and are oversubscribed. When IPOs of new loss-making companies are underwritten with great enthusiasm, most investors tend to sell their long-term wealth-creating stocks to participate in new stock ideas that get full attention. moment.

As investors, we need to remember the basic success rate when making investment decisions in new age start-ups. Most likely, few of these companies could become wealth builders in the future. Whether all new age businesses are going to operate like Amazon or Netflix is ​​an important assumption to make, and only long-term evidence can support such a strong narrative.

Predictive power

Another sign of market exuberance is to check the degree of confidence of market participants in future forecasts. Past projections on market earnings estimates may be very optimistic, but the reality is grim for many reasons. For example, for the year 2020, the NIFTY EPS estimate was 650 plus when it was originally forecast in 2019. The actual EPS turned out to be 453.

We must allow the companies in which we invest to exceed our prudent expectations.

Small cap trades

In recent months, the increase in volume traded for small cap stocks is much higher than for large cap stocks, more liquidity and a larger investor base. Trading or investing in stocks that are lightly traded or have less institutional coverage should be kept to a minimum. As the tide turns, companies with poor fundamentals could see permanent declines from current price levels.

By April 2021, the volume of NIFTY Smallcap was 30-40% of the volume of NIFTY 100 and by the first week of July 2021 it had grown to 55%.

Sudden rise in valuations

In each market cycle, a few sectors or types of stocks get the most attention. Here is an example of a business that has had a big tailwind due to COVID-19, which has resulted in a sharp increase in business. Profits nearly doubled between FY20 and FY21, a time when our economy suffered one of the worst contractions of our lives. In addition to this high earnings base, the stock is currently trading at 75 times reported earnings; it was trading within a 20-25 12-month price / earnings range, as has been seen in the past.

As investors, our job is not to get too excited about just the current earnings growth. We must focus on sustainable growth in the medium term and avoid paying too much in order to improve our safety margin.

As investors we don’t have the ability to predict the future, but what we can do is seek out all the evidence around us dispassionately before making any decisions. Protecting downside risk is one of our main missions, in addition to generating long-term sustainable returns.

(The author is Head of Research and Co-Fund Manager at ithought Financial Consulting)


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