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Sunday, August 31, 2008

Sensex in a narrow band

For the past two weeks, the Sensex has moved sideways in a band between 14000 and 14700.  Friday's 500 point rally was 'resisted' by the 50 EMA. So what is interesting about this situation? It is another textbook example in technical analysis.

Those who understand and interpret Elliott Waves (and I'm no expert) may recognise that the fall from the top of 21000 in Jan '08 happened in 5 waves - three down and two up.  The Sensex then retraced to the 17500 level in 3 waves - two up and one down.

Again the Sensex dropped from 17500 to 12500 in 5 waves - three down and two up. This was followed by a 3 wave move up to 15500.  So from the Jan '08 top we had two down movements of 5 waves each and two up moves of 3 waves each.

Now we are into the 5th (and final?) down move from 15500. The drop from 15500 to 14000 is almost an exact 50% Fibonacci retracement of the last up move (i.e. 50% of 15500 - 12500).

The two weeks sideways movement indicates a pause or a consolidation before the next move. Such a sideways movement can be an 'accumulation' (stronger and smarter investors buying; weaker investors selling) or a 'distribution' (smarter investors selling and weaker investors buying) phase.

We won't know the outcome of this sideways phase till the Sensex breaks up above 14700 or down below 14000. But we can make some educated guesses based on the fundamental and technical scenario.

The macro scene isn't great. Inflation has dipped marginally but is still at 13 year highs. Oil prices have moderated, but this has been largely offset by the fall in the Rupee value. Interest rates continue to remain high. Falling industrial production figures don't provide much hope. On top of all this, a large number of rights issues and IPOs are waiting in the sidelines to hit the market. That will suck out a lot of liquidity - which is poor anyway.

To top it all, the technical indicators like the moving averages, MACD, stochastics are mostly bearish. So my educated guess is that the Sensex will break downwards from the sideways phase of the past two weeks and then test the previous low at 12500. It may even break 12500 and touch 10000 levels to complete the 5 wave down move from the Jan '08 top.

But the markets are known to do the exact opposite of what the 'experts' may interpret. Please keep an eye on the Sensex levels over the next week or two as the consolidation phase should come to an end within that period.

In the next few posts, I plan to short-list some stocks that can be put on a watch-list for buying. That means I will give adequate reasons why I like them - but you must do your own research if you do decide to buy.

Tuesday, August 26, 2008

Your portfolio of stocks and mutual funds - why you shouldn't diversify

Investment analysts and the pink papers cry themselves hoarse about why investors must diversify their portfolios to mitigate risk and enhance returns.

This is another one of those investment myths that need debunking. Peter Lynch coined the term di'worse'ify about companies who enter unrelated areas of activities. The term applies equally well  for investors.

50 stocks or 20 funds in the portfolio is a classic case of di'worse'ification. Individual investors should try not to have more than 10 stocks or 5 funds in their portfolio. Otherwise it takes too much time and energy to keep track of the performance of individual shares and funds.

The richest individuals in the world tend to have extremely concentrated portfolios. Think about Microsoft's Bill Gates, Oracle's Larry Ellison, Walmart's Sam Walton, Infosys' Narayanmurthy.

While the average investor like you or me can't be compared with the legends mentioned, we can reduce risk and enhance wealth by placing a few concentrated bets on outstanding stocks. The key word here is 'outstanding'.

If you prefer particular sectors, avoid sugar or cement or real estate that give you windfall profits one day and huge losses on another. Concentrate on defensive sectors like FMCG and Pharma. You'll get steady and regular returns through price appreciation and dividends. And the downside will be limited.

So here is a formula for investment success. Buy a few outstanding stocks from the FMCG and Pharma packs - like Colgate, Hind Lever, ITC, Nestle, Glaxo, Lupin, Sun Pharma. These will provide steady returns and limit your losses during bear markets.

Balance such a sector tilt with stalwarts like Reliance, L&T, Bharti, Tata Steel, M&M. For a little extra, albeit risky, return add the odd Maharashtra Seamless and Opto Circuit.

Mutual Fund investors can buy a couple of diversified equity funds (like HSBC Equity, DSPML Top 100, Sundaram Select Focus), a couple of Balanced Funds (like HDFC Prudence, DSPML Balance) and an ELSS fund (like Magnum Tax Gain or Sundaram Tax Saver).

If you feel that such a portfolio is boring or uninteresting, then that is a very good indicator that you will make very good returns! For excitement and adrenaline flow, you can always visit Las Vegas or the Mahalaxmi race course!

Sunday, August 17, 2008

Making sense of the Sensex

It is time to take another look at the Sensex technicals, as some interesting price movements happened last week. The sharp bear market rally seems to have come to a halt.

After a steep month-long rise from the low of 12500 made on July 16, the Sensex reacted from a level of 15600. This 3100 points up-move was almost an exact 61.8% Fibonacci retracement of the 5000 point fall from the previous top of 17500 (17500 - 12500 = 5000; 5000 x 0.618 = 3090; 12500 + 3090 = 15590; Q.E.D.).

Equally interesting is the behaviour of the 20 EMA and 50 EMA on the Sensex chart. The 20 EMA has moved up from below to touch the 50 EMA which has flattened out. The Sensex low for the week has touched the confluence point of the 20 EMA and 50 EMA.

Why is it interesting? This looks like an intermediate trend deciding situation. If the Sensex bounces up from the confluence point, then the 20 EMA will also penetrate the flattening 50 EMA. That will provide a short-term buy signal, which will be confirmed when both the 20 EMA and then the 50 EMA crosses the 200 EMA from below. 

What if the Sensex continues its downtrend? The 20 EMA will start moving down after touching the 50 EMA and both the 50 EMA and 200 EMA will continue downwards. All signals will be bearish again.

There are some more indicators in the chart which I will discuss on later posts. Both the Stochastics and MACD indicators are suggesting a downward movement. Last week's much higher inflation rate and depreciating Rupee may further aggravate the downtrend.

But Mr Market plays by its own rules. So watch the Sensex movements closely during the forthcoming weeks. If the Sensex moves below 13000, I am going to buy some more. Probably frontline Sensex stocks.

Saturday, August 9, 2008

If you must SIP, sip good Darjeeling tea

Edward Luce, the Financial Times correspondent who was stationed in Delhi and is now at Washington DC, has written an eminently readable book on the challenges faced by the growth story of modern India. Called "In Spite of the Gods", the book postulates that the reason for the success of a vibrant democracy is India's diversity.

This diversity can be exemplified by how tea is prepared in different parts of India. In the west, tea leaves, water, sugar and milk are brought to a boil in a pan. In the north, spices like cardamom or ginger or both are mixed with the tea to make 'masala chai'. In the south, coffee is the preferred drink, though a large quantity of tea is grown in the Nilgiris.

In the east, there is Assam tea - a strong rich brew prepared with milk and sugar. And then there is the queen of teas - Darjeeling - whose beautiful bouquet and light taste emerges only if it is brewed in a pre-warmed porcelain tea pot and sipped without adding milk.

That brings us to another SIP, or a Systematic Investment Plan (another of those investment myths!). A disciplined and conscientious investor should have no problems with saving a fixed amount of money every month or every quarter. But is it necessary to invest that sum every month or every quarter on a particular date?

The fund managers of most Mutual Funds will say a resounding "Yes".  They even provide examples on offer documents or on business channels to prove their point that investing a fixed amount on a particular day every month or every quarter is the way to untold riches.

Like a dummy, I listened to their collective advice and started a 12 months SIP in a well known diversified equity fund in the middle of 2004. By the time my 12 monthly installments were complete, I found to my horror that my average price per unit had continuously climbed up - along with the stock market. For my last monthly installment, units cost as much as 40% more than the units bought with the first monthly installment!

One lives and learns. The only people who get rich from your SIP is the fund manager. SIPs provide a steady monthly (or quarterly) revenue to the fund without the fund manager spending any time or effort in selling the fund.

In a trending market - whether it is moving up or down - a SIP will always make your average cost per unit much higher than the cost you will incur at the beginning of an up trend or the end of a down trend.

Is a SIP completely worthless? No, it works if a market is moving sideways - some times up and some times down within a range - without a clearly discernible up trend or down trend. How often do such sideways movements happen?

Not very often, and even when they do, they last for a short period of 3 weeks to 3 months - not long enough to benefit from the price averaging that a SIP will provide.

So heed a word of advice. Buy some good Darjeeling tea and learn how to prepare a proper brew. Savour the taste and flavour by taking small sips. And avoid SIPs.

(Note: No, I haven't joined a tea company. But I have alluded to another investment myth: Timing the market vs. Time in the market. That myth will get debunked in a future post.)

Saturday, August 2, 2008

Don't be a bull or a bear in the stock market, be an African python

The triangular headed South African python is a truly awe-inspiring reptile - massive in length and weight, immensely strong with an intricately patterned shining skin. The other day, on the National Geographic channel, the camera followed such a beauty as it slowly slithered through the bushes and weeds and glided into a watering hole.

There it hid with only its snout above the water - and waited patiently. Day followed night and night followed day - and still it waited. Animals big and small, arrogant and shy, came to the watering hole for a drink. The python didn't move.

Six days and nights passed - and no body except the camera-person knew that the python was lying in wait. On the 7th evening a herd of deer came for a drink. A younger and frisky member ventured a little further from the water's edge - unaware of the peril.

Suddenly, the water hole exploded into action. With its immense muscle power, the python lunged out like greased lightning and in the blink of an eye had wrapped itself around its prey. The poor animal probably didn't even know what hit him.

The South African python is used to spending weeks and even months without feeding. Some times it eats the odd rodent or bird. But when it really wants to eat, it plans its every move and with infinite patience grabs a large meal so that it won't have to eat for a long time.

Like the python, a successful long term investor does not need to 'feed' (i.e. trade) every day or every month. Once in a long while, the stock market provides an ideal opportunity to grab a few frontline stocks at mouth-watering prices. Back during the 2002-2003 bear market period, stocks like Tata Steel was available at 100, M&M at 90, ITC at 60 (actually 600 for a Rs 10 share). All three subsequently offered bonus shares at 1:2, 1:1 and 1:2 ratios respectively.

There were many other shares going for a song and which made a ton of money for savvy long term investors. Since then, we had a one-way bull-market with V-shaped corrections in 2004 and 2006. But after 5 long years we are now in a full-fledged bear market which seems to have completed its first leg at 12500.

For long term investors, this is the right time to behave like the python. Don't jump yet. Conserve your muscle power (i.e. cash), decide on a few target companies and wait patiently for the market to exhaust its second leg. This will possibly happen in the 15500-16500 range. (A few 'dud' shares in your portfolio can be sold in that range.)

The Q1 results declared so far show that top line growth has been satisfactory for most companies. But margins growth has been far lower and below expectations. With inflation rate still in double digits, interest rates are unlikely to come down any time soon. The lower oil prices and political stability are the silver linings.

The Q2 results are likely to be worse than Q1. The market will probably have a third leg down to test the 12500 bottom, and panic and doom will be all around. Time frame should be around October. That will be the right time to lunge.