Trading Rule – “Watch out for those silent early warning signals”

THE BEAUTY OF THE MARKETS IS THAT NOTHING STRIKES WITHOUT A WARNING. BE IT THE DEFAULT BY VIJAY MALLYA OR THE BANKRUPTCY OF SATYAM COMPUTERS OR THE CONFLICT OF INTEREST CASE IN ICICI; THE STORY IS ALWAYS THE SAME. THE MARKET GIVES AN EARLY WARNING SIGNAL IN A NUMBER OF WAYS. FOR EXAMPLE, THE MARKET SIGNAL COULD COME IN THE FORM OF LOWER P/E VALUATION DESPITE ROBUST PROFITS. ALTERNATIVELY, THE SIGNAL COULD COME IN THE FORM OF PRICE WEAKNESS EVEN WHEN THE OTHER STOCKS IN THE SECTOR ARE GIVING POSITIVE RETURNS. SIGNALS ALSO COME IN THE FORM OF SPURT IN VOLUMES AND AT TIMES EVEN AS WEAK VOLUMES

HOW TO READ AN EARLY WARNING SIGNAL?

One of the basic truths that every trader needs to understand is that the market always has a story to tell. This could be in the form of higher volumes, price volatility, industry underperformance, index underperformance etc. As a trader, your primary job is to read these signals, decipher the message and do your owner homework before taking your own trading decision. For example, before the Satyam fiasco, there were a number of clear indications. The volumes had shot up, institutions were gradually exiting their positions and there was clear short accumulation in the futures. Obviously, the stronger hands in the market had understood that something was amiss in the stock. Similarly, ICICI Bank and Axis Bank were consistently getting lower P/E valuations from the market despite robust numbers. The reason became obvious when their NPAs turned out to be shockingly higher and there were also serious questions over some of their credit decisions. Keep an eye!

WHAT SHOULD YOU DO WHEN YOU SPOT THESE SIGNALS…?

It is one thing to spot a signal and another thing to act upon it. In fact, acting is a lot harder. The question is whether you should act immediately or whether you should wait for further ratifications. The question is whether you should act absolutely or whether you should act relatively. Clearly, there is a 3-pronged approach to take this decision based on the signals. Firstly, apply the test of consistent signalling by markets. If you get an odd signal that could be noise but if you get signals from multiple indicators like price, volumes, futures, options and institutional selling then you must take these signals seriously. Secondly, you need to apply the relativity test. Are the signals restricted to that stock only or are they spread across the sector or theme? For example, in 2011 the negative signals were visible across the capital goods sector. Lastly, apply the test of corporate governance. This is a very important test and as Mr. Narayana Murthy says, this normally seals the deal. If you put awkward questions to the management and don’t get satisfactory answers then you must believe the signal.

“In the long run, markets are a weighing machine. In the short run, the markets are a slotting machine, but the signals give are priceless” – Market Wisdom

6 WAYS T0 ACT ON A MARKET SIGNAL ONCE IT IS CONFIRMED

  1. Once you are clear that the market signal is credible and also meaningful, what should be the next step? Your first step reaction should be whether the problem is temporary or permanent. If the problem is temporary, there are a number of ways you can play it. You can choose to exit the stock and wait for a more opportune moment to buy back that stock. Alternatively, you can choose to either sell futures with the intent of buying back or buy put options to make the best of the downside risk.
  2. If a signal is more of a structural nature; like PSU banks in 2014 or capital goods in 2011, then you can actually crystallize a negative view on the stock. You can either exit your cash positions entirely or keep rolling short futures or you can start buying distant OTM put options. The idea is that since you have caught the signal the right time, you can as well make the best of it on the downside. You do not consider buying it back unless you are clear that the structural issue is sorted out.
  3. When the market is signalling a major underlying problem like we saw in the case of Kingfisher, Deccan Chronicle or even in the case of Amtek Auto and Bhushan Steel, it is best to think with your feet. Your primary task is to cut your losses to the bare minimum and just exit your trading positions. Don’t try to make money out these positions.
  4. Use the signal to recalibrate your trading strategy and your positional mix. If your original idea was to keep a certain allocation to a sector or stock then you need to revise that strategy and re-allocate your funds accordingly. Also, your trading strategy on that entire sector or theme needs to undergo a change.
  5. One of the common problems you face in such cases is overnight risk. For example, if you get signals on a stock that you are substantially exposed to, how long should you wait. The underlying rule is that overnight risk should be avoided when you get these signals. That may mean taking a loss in a position; and you may be proved wrong. But that is immaterial because your first task is to avoid the overnight risk.
  6. When you get macro cues, rework your macro themes. For example, when the market absorbs signals of a possible rate hike, you must immediately rework your allocations to rate sensitive positions in banks, NBFCs and real estate. Also any signals in terms of risks to market P/E, or risk to market P/BV or even risk to market dividend yield, must be built immediately into your macro assumptions.

LISTEN TO THE MARKET SIGNALS AND ACT FAST

More than grasping the signals, it is how you act upon these signals that really make a difference to your trading performance. The moral of the story is that the market is designed as an advance warning system for traders. It is for you to comprehend these signals and calibrate your trade rather than trying to question the market rationale!

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