In search of the holy grail – Exit at the top & Enter at the bottom strategy

When I entered the investment world, I had a simple wish – to figure out how to enter exactly before a bull market, ride the wave and get out at the top.  Once I figure this out, I will be rich and can spend the rest of my life whiling away on the shores of some exotic beaches.

Let me take you through my journey in search of the holy grail..

Someone somewhere should have figured it out..maybe the mutual funds

I started with the logic that “If market timing was possible, someone somewhere must have figured it out”. My job is to figure that someone, somewhere.

In India, who do you think will be the most interested in solving this problem?

While all of us would obviously want to know the answer, the mutual fund industry has the highest incentive to figure this out as their entire business is based on providing returns.

Sample this – the top 3 mutual fund companies – HDFC, ICICI Prudential and Reliance make a profit of above INR 500 cr each.

This means they have enough money to subscribe to the best of research, tools, technology and hire the best of the brains.

Here is a sample of what the industry was paying its fund managers in 2016

Good. So hiring talent wouldn’t be an issue.

Most of the fund managers are very experienced, have great long term track records and have spent a long time figuring out processes to make money in the stock markets.

So logically someone from the mutual fund industry should have figured it out right?

Going back to 2007 – just before the 50-60% crash due to the global sub prime crisis.

Prashant Jain – HDFC Mutual Fund (26-Nov-2007)

Do you see a market crash in the near future?
In my opinion, a “crash” is probably too strong a word for the Indian market. But a correction can never be ruled out. It is true that the Indian market is somewhat expensive, but it offers a unique combination of size and growth. Global investors are increasingly looking at India as a mainline asset class and are therefore, investing with a long term view. If you look at Indian P/E’s of nearly 20, 15-20 per cent earnings growth, interest rates of 4-6 per cent prevailing outside India and an appreciating currency, then Indian P/E’s still look reasonable. India is somewhat expensive compared to the past and to the prevailing interest rates locally. But when viewed in the global context and in view of improved size, fundamentals and visibility of the Indian economy, the market does not appear to be unreasonably valued.

Source: Link

Mahesh Patil – BSL MF (28-Nov-2007)

Do you see a market crash in the near future?
I don’t see a major market crash in the near future. The long term trend is still up. However, after the smart rally we have seen in the last few weeks, one can expect a short correction of about 5-7 per cent in the near future.

Source: Link

A Balasubramaniam – Birla Sun Life AMC (24-Dec-2007)

Do you see a market crash in the near future?
During the recent run up of the market, post the US Fed cutting the Fed rate, we have seen the CNX MidCap under perform the larger indices. This has resulted in an increase in the valuations gap between large- and mid-caps. We analysed the results of all manufacturing companies in the BSE 500. We saw sales rise by 24 per cent while PAT grew by 70 per cent on year-on-year basis. Given the lower the inflation and a softer interest rate regime, we expect the coming quarters to go quite robust. This would widen the valuations gap between large- and mid-caps further. Hence we believe mid-caps would be very attractively valued.

Source: Link

Birla Sun Life AMC Factsheet (31-Dec-2007)

Investors have now started worrying about a possible US recession and the consequent impact on the emerging markets including India. We believe that a near recessionary US economy is unlikely to have as significant an impact on emerging markets as in the past. Indian economy, is resilient to the impact of any potential US slowdown (domestic consumption driven and low export-to-GDP ratio at about 15%). India has diversified its exports base – commodity and country wise – share of US exports now stands at 15% of India’s total exports from 22.8% in FY2000. Research indicates that for every 1% fall in GDP growth in the US, India’s growth will only be affected by 0.25%.

We believe India is entering a period of increased stability with limited impact on growth. India’s level of trend growth is expected to be sustained at  8% plus, due to  improved  macroeconomic stability, liberalization in a number of key areas and gradual improvement in infrastructure.”

Srividhya Rajesh – Sundaram AMC (6-Dec-2007)

Do you see a market crash in the near future?
While we are of the opinion that there may be a bubble (in terms of valuations) being formed in the market, we do not forsee it being pricked in the near future. Given the global liquidity conditions, we expect the bubble to last longer.

Source: Link

Anand Shah – ICICI Prudential AMC currently the CIO of BNP Paribas Mutual Fund (20-Dec-2007)

Do you see a market crash in the near future?
The rise is the reflection of very strong GDP growth rates in the last three years and expectation of the same being sustained in the foreseeable future. We believe that strong earnings growth of India Inc will sustain going forward and thus market valuations are reasonable on a one-year forward earnings basis. Also, the balance sheet of India Inc is stronger then ever. We are of the opinion that the market might remain volatile in times to come, however a market crash is unlikely.

Source: Link

ICICI Prudential AMC Factsheet (31-Dec-2007)

As we step into 2008, Indian economy seems to be in fine shape, more capable of handling global slowdown than many peers. Globally, subprime related issues are resulting into credit squeeze. Banks are worried to carry out normal borrowing and lending amongst each other. ECB and US Fed are pumping liquidity to ensure that credit squeeze does not result into recession. Our feel is that with minor hiccups central banks world over will be able to stimulate global economy with series of rate cuts, pumping of liquidity and pro-growth statements.

Indian economy aided by domestic growth is likely to be an oasis of growth among the global desert. Q3FY08 results are likely to be in line with market expectations, except for some treasury gains or losses which are difficult to forecast. Big queue of IPOs and QIPs expected in 4QFY08 will keep up the supply pressure and also maintain momentum. FIIs, after turning sellers of Indian equities in 3QFY08 will have to think twice before selling in 2008. Chinese markets are running at higher valuation than Indian markets and as long as that gap is maintained, there is not much worry on the de-rating of Indian valuations. The domestic investors led by retail, insurance companies and mutual funds are taking lead over FIIs in articipating in Indian equities.

Net-net, the outlook for Indian equities in 2008 seems to be positive on the back of:

• Economy, which is likely to grow above global average based on domestic factors
• Valuations which are at premium over other EMs but at discount to China H share market
• Domestic investors now stepping up to take lead over FIIs

Thus, despite the mutual fund companies having the best of intentions, best of brains, great long term track record, enough money to deploy the best of technology and vast research resources –

Yet, none of them were able to predict the short term!

Maybe your wealth manager..

The notion before joining my organization (a reasonably large and reputed wealth management firm currently handling around 10,000 crs in AUM) was that, “Hey, here are these guys advising the richest of the richest. Obviously they must be knowing the secrets to make quick money. Let me figure this out and get my life sorted!”

7 years down the line, after having the fortune to have interacted with some of the best investment minds, getting to work along with some of the largest family offices,  figuring out what the other wealth managers are upto and doing all permutation and combinations of trying to figure out a precise timing model, I realised –

None of us can predict the short term!

Maybe Mr Warren Buffet

Here is a man who is currently the second richest in the world!

He has a 52 year track record of compounding at 21%!

He reads 500 pgs every day!

He is accompanied by yet another genius – Charlie Munger!

And yet they too weren’t able to time their way out during a correction and had to go through several corrections – 49% down in 1974, 23% down in 1990, 20% down in 1999 and 32% down in 2008!

Oops! Even Warren Buffet and Charlie Munger can’t predict the short term!

Maybe the other popular global fund managers..

Prem Watsa referred to as Canada’s Warren Buffet:

While his hedging of equity portfolio made a killing in 2008, he has been quite wrong for several years since 2010-2016 post which he took a U turn on his call and removed all his hedges.

March, 2010: “Our reading of history—the 1930s in the U.S. and Japan since 1990—shows in both periods nominal GNP remained flat for 10 to 20 years with many bouts of deflation.”

March, 2011: “Even onions and chilis went up 64% and 38% respectively in 2010!! We shy away from parabolic curves, so we continue to maintain our equity hedges!”

March, 2012: “Ben Graham’s observation that ‘only 1 in 100 survived the 1929-1932 debacle if one was not bearish in 1925’ continues to ring in our ears!”

March, 2014: “While it is very painful and costly waiting, we think your (and our!) patience will be rewarded.”

March, 2015: “While the deflation derivatives are very volatile, if we are right, these derivatives may become as valuable as our CDS derivatives became in 2007/2008.”

March, 2016: “We have warned you many times in our Annual Reports of the many risks that we see and the great disconnect between the markets and the economic fundamentals. These risks may be coming to a head in early 2016, as I write this Annual Report to you—right out of the blue!”

Howard Marks in one of his recent memos

“The memos that have raised yellow flags in the current up-cycle, starting with “How Quickly They Forget” in 2011 and including “On Uncertain Ground,” “Ditto,”and “The Race Is On,” also clearly were early, but so far they’re not right (and in fact, when you’re early by six or more years, it’s not clear you can ever be described as having been right).

Since I’ve written so many cautionary memos, you might conclude that I’m just a born worrier who eventually is made to be right by the operation of the cycle, as is inevitable given enough time. I absolutely cannot disprove that interpretation. But my response would be that it’s essential to take note when sentiment (and thus market behavior) crosses into too-bullish territory, even though we know rising trends may well roll on for some time, and thus that such warnings are often premature.

I think it’s better to turn cautious too soon (and thus perhaps  under perform for a while) rather than too late, after the downslide has begun, making it hard to trim risk, achieve exits and cut losses.”

 

Other famous investors such as Jeremy Grantham, John Hussman, Seth Klarman, Bill Gross and James Montier etc have all sounded the warning bells in the last few years which is yet to play out.

These are some of the best guys, who had navigated the earlier sub prime crisis and dot com bubble successfully. Even these guys as seen above haven’t been able to get the direction of the market right in the short run.

Simply put, predicting what the markets will do in the short run is hard, in fact damn hard and almost impossible to do on a consistent basis. You can be amongst the best investors with a superb long term track record and yet the short term is still too random to predict.

Most of these experienced investors realize this and usually take calls which work over a longer time frame and look at producing reasonable returns over a complete market cycle (i.e periods covering both ups and downs).

Their intent is not to predict the future, but to evaluate the risks and margin of safety in the present scenario and correspondingly adjust their portfolios. This implies going through a period of pain where they look wrong and the key is to have the patience and conviction to stick to the decision which is far easier said than done.

If this is the case for the best investors, then we need to realize the fact that the utopian world where we don’t fall but yet capture the equity returns upside is extremely difficult pull off on a consistent basis. Or to be honest, I would put it as wishful thinking.

How do we deal with this?

This brings us to the uncomfortable question, if experienced investors find it this difficult then then how do we normal investors deal with this uncertainty.

My answer is simple – we accept corrections as a part of life rather than trying to avoid them.

And hence, the maximum extent of decline which we are ready to accept will decide our equity exposure.

Here lies the proof of the pudding – Indian fund managers despite their inability to predict short term returns have had a phenomenal long term track record.

So lets wrap our heads around this new perspective of actually facing the corrections rather than trying too hard to completely avoid them

• Equity market is all about faith: Equities in the long run is basically a bet on human progress. You are simply betting that entrepreneurs (who take higher risks) on an aggregate will get compensated with higher returns
• Market corrections are not a bug but a feature – and it is next to impossible to predict when the next one is coming, how steep the decline would be and how long it will last
• It is prudent to assume that our equity portfolios will go through a 30-50% decline at-least once in every decade
• 10-20% corrections should be expected to be a regular affair
• It is ok to realise that you wont be able to predict the fall and in fact you don’t need to predict the fall to create long term returns
• The way you behaviorally respond to a fall (which is completely under your control) is all that matters for your long term returns
• Now if you won’t be able to handle a decline of such an extent, it is better to reduce the equity allocation correspondingly and use a combination of equities and debt
• A plain vanilla, disciplined re-balancing strategy to maintain your equity allocation on top of this is a simple yet effective strategy
• While short term is still too random, taking a slightly longer view – as witnessed from the best of investors its possible to develop some reasonable and approximate estimates on expected equity returns (based on mean reversion in valuations and profit margins)
• You can check out my framework to estimate 5-7 year returns here
• If the estimated return environment is extremely low, you can focus on reducing overall risk (avoiding overvalued segments and practicing adequate diversification)
• Also remember that valuations are an indicator of risk and not a precise market timing tool – so if you are under weighting based on valuations, the actual time taken for the risk to manifest (based on the catalyst) is anyone’s guess. So be prepared to have the conviction and patience.As Keynes mentions – The market can remain irrational longer than you can remain solvent

• Overall a simple asset allocation + re-balancing + lower costs + long time frame + focus on risks + faith in equities + sticking to the plan = good enough investment returns
• And repeat “No one can predict the short term returns”

This is an evolving framework and would love to hear your thoughts. Do you think it is possible to time the markets?

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If in case you need any help regarding your investments or want me to write about something, feel free to get in touch at rarun86@gmail.com