Did you witness stock market rally lately!
But, how can your clients take advantage of it?
Believe me! It's easy. You just need to get the basics right.
You need to understand first "is it a rally"? "What led to such a rally?" "How long will it sustain?"
You call a period a rally when you witness a sustained increase in the price of stocks. Rally can be a bull market rally or bear market rally. The force which leads to a surge in prices is the demand. Due to increase in demand, there is a massive inflow of investment capital which pushes the prices upwards.
How long this phenomenon continues ultimately depends on the number of buyers vis-à-vis sellers. A rally will continue for the relatively long duration in case of buyers greater than sellers. However, prices are likely going to turn southwards if there are an equal number of buyers and sellers.
Your client’s investment horizon too, determines what constitutes a rally. If one is a long-term investor, then minor price swings may not affect your investment decision. You might analyse a longer period say a quarter to identify a rally. Conversely, for a day trader the price surges in the first half of the trading session as a rally.
Hence, the perception of a rally can be subjective depending on one’s time frame, as an adviser you need to understand that an investment should always be goal-bound & horizon-bound.
What causes a rally?
There can be several reasons behind a market rally. Some are short-lived while others can be profound.
Short-term rallies result from news or events that distort demand-supply equilibrium. These can be like block deals in a sector or appointment of a new CEO by the company's board. For instance approval of a drug by the US FDA leads to a rally in stock prices of the Indian pharmaceutical company.
Long-term rallies are caused by changes in macroeconomic factors like government's fiscal policy; RBI's key rates change announcements, etc. For instance government's decision to relax FDI norms in retail sector would create a rally in the equities markets.
How to identify a market rally?
Equity Analysts use a range of tools to identify a market rally. They use price movements and trading volume data to ascertain robustness of a rally. They would try to interpret charts which fall under the purview of technical analysis.
Technical analysis is the best way to determine a rally. While using this, you need to follow the basic assumptions. You need to assume that price is the best indicator of the worth of the stock. Market Price incorporates all sorts of information required to make a buying/selling decision.
Price moves in trends. It follows a pattern which can be understood. You may use this trend towards forecasting price movements.
The final assumption is that history tends to repeat itself. It helps you to predict market psychology.
You can use "Rate of Change" indicator to identify a stock market rally. It involves comparison of today's closing price with the closing price X days ago. Usually, you may take a normal time frame of 10 days.
Mathematically, it's represented as follows:
Rate of Change (ROC) = (Y/Yx)*100
The ratio will indicate the trend prevailing in a particular security or the market as a whole. Suppose today's closing price of XYZ Ltd is Rs 289. The closing price of the company 10 days ago was Rs 294.15. Applying the formula gives you the ROC as 98.25%.
Now, you need to compare this with the equilibrium, i.e. assumed to be 100%. If ROC is greater than equilibrium, it means a short-term bullish rally has begun. If ROC is less than equilibrium, it means a short-term bearish rally has begun.
You can also use it for a long-term view of the market or a particular sector or stock. For that, you may use a 26 to the 52-week period. In this way, you can determine the direction and duration of the market in a better manner.
What to do during a market rally?
Rallies keep happening now and then. But slumps too succeed a rally. You can only think in probabilistic terms as regards duration of a rally.
You must not discourage your clients from gaining the advantage of the situation. After all, it's good to ride the equity wave. But that also requires a strategy. Without a plan, you may end up losing your money.
Investors can follow these generic thumb rules to stay rational during a market rally:
- Mode of investment
Investment manner has to be adjusted according to the mood of the market. Especially in case of equity mutual funds which are so much affected by market movements. You need to avoid placing larger bets in the form of a lump sum.
Instead, try to play safe during a bullish rally. You may initiate a Systematic Transfer Plan (STP). It can be done to allocate assets from a debt fund to an equity fund.
- Asset allocation strategies
In this, you decide the asset classes in which the money needs to be pooled. During a market rally, the P/E ratio of small-caps & mid-caps tends to surge. These become pretty expensive and risky bets. You can't be sure whether these hold enough water to sustain the growth. It's because portfolios which are skewed towards mid-caps& small-caps tend to perish at the end of the market rally.
You need to tread carefully during market exuberance. Start tending your allocation towards large-cap equity funds. These may be unable to beat the benchmark but maintain portfolio return within expected levels during a rally.
Avoid penny stocks as far as possible. You don't know if there's any circular trading at play which is pushing the price upwards.
- Manage portfolio risk
Investors often get polarized towards getting higher returns. They forget the other face of investing, i.e. risk management.
For a portfolio composed of different asset classes, it might get skewed towards equity. For an equity-diversified portfolio, it might get skewed towards small-caps & mid-caps. You need to avoid portfolio concentration as far as possible. Try to achieve maximum diversification.
As the market tends northwards, portfolio allocations tend to change. Rebalancing can be done to bring keep portfolio risk intact.
You may use the following rebalancing strategies:
- Strategic rebalancing – It involves bringing back the asset allocations to target allocations
- Dynamic rebalancing – It entails increasing equity allocations to take advantage of the market rally.
However, the rebalancing should conform to the risk appetite and investment horizon of your client. If your client is risk-averse and has a short-term horizon, go for strategic rebalancing; bring back your allocations to the original ones.
On the other hand if your client is a risk-seeker, having a long-term horizon, may experiment with dynamic rebalancing.
KishorKumar Balpalli is the founder of
mymoneysage.in, an online investment platform for advisers.
