Profiting + Saving Yourself by Recognizing Patterns

The market, like real world rarely plays out like it does on a spreadsheet. So as investors, we should build in the expectation of losses into our investment process. Nothing wrong in accepting what is a brutal truth.

But apparently, many market participants (unfair to call them investors) don’t like this truth.

When things go according to their wishes, they first turn confident and then overconfident and finally, enter the zone of hyper-confidence. But the market is very powerful and can be brutal. We need to become more humble as the market goes our way [Bernard Baruch]. People in bull markets become like the magician who starts believing in his own magic. Sooner or later, he will be punched in the face.

So what should one do?

To be honest, very few people are real good stock pickers who can find profitable investment ideas immaterial of whether it’s a bull or a bear market. But unless this ability to pick the right stocks is backed with an intent to allocate big money to those ideas, stock investing is not a gamechanger – something that most market participants wish for.

Luckily in investing, having a normal IQ is just fine. It’s not as damaging as having a poor EQ. The best part is that a normal IQ is enough to make you aware of the possibilities in stock markets.

The possibility that markets don’t go up in a straight line. The possibility that the good times are followed by bad ones and so on…

And to actually gain knowledge of these possibilities, you need to be aware of the market history.

Patterns and trends do matter in markets. There’s no disputing that. But it’s more important to recognize those historical patterns. Here is one such pattern that I have reasonable faith in:

Read more about it in this annual study of index PE that I do every year.

We are currently above PE25 for Nifty (last time I checked).

And it won’t be wrong to say that from given valuations and the froth that has set in mid-&-small cap space, we will find it difficult to make good money (broadly speaking) from these levels. Ofcourse, there will be some sectors which are undervalued. But unless you are invested in those sectors or stocks, chances of making money are pretty low if you look at it purely from a valuations’ perspective.

Recognizing larger simple patterns in the market (like one in above table and another interesting one) help investors make quick deductions with confidence:

• If market valuations are very high, it’s best to have lower expectations from future returns
• If market valuations are very low, it’s time to bet big with the expectation of higher than average future returns

Coming back to the present and taking the liberty of painting using broad strokes, it’s clear that markets are overvalued. Whether it’s a bubble or not is another thing. Maybe it’s not. Just doesn’t feel like it still. 🙂 But market excesses punish everyone. If not equally then in proportion of their portfolio’s allocation to overvalued vs undervalued positions.

But beware – trying to recognize patterns comes with its own share of risks. It pushes us to draw out conclusions and if left unattended to, this can become uncontrollable. We start seeing patterns where none exist and more importantly, start making investment decisions based on these non-existent patterns. And that is where the magic of the magician (who believed in his own magic) ends. 🙂

Talking of patterns here let me be clear about something – I do not belong to technical analysis school of thought. That’s not my area. But I also prefer not to restrict myself to any particular investing framework or style.

I am valuation and quality conscious long-term investor. So more or less, that is how my mind works. But if there are some small tactical positions to be taken for a comparatively shorter term and where money is more or less to be made easily, I position myself accordingly. You may call it having a double standard. But that’s fine. I am a simple guy. I don’t want to be right or wrong. I just want to make money. 🙂

Smart money moves are not complicated. They are simple.

If current valuations say that future returns will be low, it’s better to take some money off the table and wait. Selling stocks that are unreasonably valued and which are not in hold-forever category, is fine. And so is investing in undervalued parts of the market even when the overall market seems highly overvalued.

You may call this trying to time the market. But again, we cannot be valuation-blind if excesses are there. We need to respect history. Buy-&-Hold doesn’t mean Buy-&-Forget.

For people who invest systematically and regularly, there is not much point in trying to time the market if the financial goals they are investing for are years away. They may get their timing right today. But may get it wrong in future. It will average out eventually. And since their approach is based on the concept of averaging, it’s best to continue doing what they are doing (unless they start feeling very uncomfortable with the current valuations or if they need money in short-term).

As usual, I have no predictions to offer.

Since the last time I wrote about this topic, markets seem to have an utter disrespect for the valuations. But we will only know in hindsight whether history repeats or not. It generally rhymes though. 😉 At present, my personal portfolio is positioned to take advantage on either side. Ofcourse not as well positioned as a pure equity or a pure debt portfolio though.

And here is an old tweet that continues to remain strong 😉

Things to do in market
PE>26 – Tk Holiday
26>PE>22 – Read books
22>PE>15 – Invest
15>PE>12 – Invest Heavily
12>PE – Take Loan/Steal & Invest

— StableInvestor.com (@StableInvestor) April 6, 2015