An investor cannot control the market he operates in, or the behaviour of others in the market. We only have control over our own actions, particularly the constituents of our portfolio, how much cash we hold and how much leverage we take. We have to adapt these actions to the external situation that is dealt to us. In markets, we cannot force outcomes regardless of how hard we try.
One of the key considerations for how an investor should position is the current state of the market cycle we are in. Due to the relative immaturity of Sri Lankan markets, they tend to operate on particularly amplified market cycles making them even more important to understand and respect.
Defining Terms
As always in the investment world, the same world can have different meanings to different people. Hence it is important to clearly define terms.
Bull Markets
The academic types define a bull market as occurring when a market has increased by 20% or more. Others define bull markets as a period when valuations are “too high”. We prefer to categorise the market based on the behaviour of its participants. Hence for us a bull market occurs simply when participants are acting “bullish”.
This is primarily a psychological phenomenon that occurs when market participants show the following characteristics:
A high sense of optimism about the future. This starts off mildly but escalates into euphoria as markets continue to rise.
A high sensitivity to positive news (i.e: even slightly positive news drives a large increase in share prices).
A low sensitivity to negative news. (i.e: even very negative news do not lead to a drop in share prices).
Prices steadily rise as the above optimism fuels more demand for shares. The market usually hits an all time high again and again.
High trading activity with high levels of market liquidity.
Increased retail investor participation.
High levels of borrowing on margin as investors want more exposure than they can afford.
A high level of focus on the stock market from people who usually are not participants. The stock market generally becomes a topic on social media and at dinner parties.
“Darling stocks” with some sort of narrative rise especially aggressively.
Increased capital market activity as companies rush to take advantage of favourable markets. (More IPOs, debt issuances, rights issues and so on). IPOs are often oversubscribed and rise sharply on open.
Anecdotal stories float around of the dentist who tripled her life savings in a month by buying one stock on maximum margin. “What a hero!, if only I was watching the market I could have done that too”
Bear Markets
Similarly, we consider a market to be a bear market when participants are acting “bearish”. This is basically the opposite sorts of behavioural patterns:
A high sense of pessimism about the future.
A high sensitivity to negative news and a low sensitivity to positive news
Share prices decrease, and the gap between price and value increase.
Low trading activity.
Low retail investor participation.
Low liquidity.
Margin deleveraging (both voluntary and involuntary), with margin calls combining with low liquidity to exacerbate price drops.
Low interest in the stock market, even from people who are supposed to be active participants. (For instance one of our brokers started pitching real estate opportunities to us in the height of the bear market).
Steadily declining prices, especially worse in the “darlings” of the previous bull market where speculative activity was at its worst.
Low capital market activity. IPOs often get cancelled as they fail to generate enough subscriptions.
Anecdotal stories of a dentist who lost all his life savings buying one stock on margin. “What an idiot! I’d never do something like that”
Like many other concepts of psychology, bull and bear markets are a spectrum. Markets generally fluctuate between mildly bullish and mildly bearish, although a confluence of factors (Munger’s Lollapalooza effect can lead to very strongly bullish or bearish iterations of the market as well. It is these raging bull markets that one should be most careful of as they lead to the formation of dangerous bubbles.
Bubbles
While bull and bear markets are defined by the behaviour of the participants, we consider the divergence between market price and fair valuation to be the primary determinant of whether or not we are in a bubble. Bubbles occur when market prices are significantly higher than any reasonable fair value. A bubble can occur in a single stock (and has done so regularly in Sri Lanka) or in the market as a whole (a much rarer occurrence). Unchecked bull markets usually evolve into bubbles as justified optimism evolves into wild euphoria. The bursting of bubbles (caused by an external shock or simply under its own weight) is usually what triggers the transition from a bull market to a bear market.
Bubbles are periods of true psychological insanity. Interested readers should study the Dutch Tulip Mania or the Mississippi Bubble for some jaw dropping anecdotes. (Like the sailor who accidentally ate a tulip worth more than most dutch houses at the time)
What we do in Bull Markets
“You got to know when to hold ‘em
Know when to fold ‘em
Know when to walk away
And know when to run”
- Kenny Rogers, the Gambler
Bull markets are characterised by rising prices and high levels of investor interest and activity. However, they usually go too far leading to the formation of dangerous bubbles. Speculative activity also increases, with the shares transitioning from more stable investors to speculators. These factors make the risk of loss significantly higher during bull markets.
Bull markets also provide many opportunities for short term trading profits. Short term traders try to buy what the herd is chasing to sell it on to a greater fool. This is not our area of expertise so we will not comment on this except to warn participants that if such a fool does not appear or does not buy the required quantity, you may get stuck holding the bag and losing significant sums when the cycle turns. And the cycle will turn. It always does. Markets are filled with stories of traders making jaw dropping profits doing high risk short term trades, only to lose it all when the cycle turns.
One of my favourite, often under appreciated features of bull markets is the significantly enhanced liquidity they provide. Sri Lankan shares are highly illiquid and it can be a nightmare to exit positions. Bull markets create a wonderful opportunity to exit mistakes (link) and
rebalance a portfolio.
We agree with Buffett’s advice to be “fearful when everyone else is greedy”. Hence generally feel bull markets are a time for increased caution and regular re-evaluation of the portfolio. We use them to rebalance our exposure, exit mistakes and build liquidity to purchase shares during inevitable market crashes. We also carefully watch for signs of bubbles forming, either in specific stocks in our portfolio, or in the market as a whole. We may decide to exit positions or reduce our overall market exposure, but this decision is made purely based on valuation.
Another distinct feature of bull markets is that they tend to be short lived. We have observed, especially in Sri Lanka, that bull markets are short and furious, burning out usually within a few months, with much longer bear markets in between. However, there is plenty of evidence in overseas markets that bull markets could also last years in the right environment. The fast paced nature of bull markets mean that quick and decisive action is key.
What we do in Bear Markets
Bear markets are our favourite period in markets. For the patient investor, they create the opportunity to collect shares in wonderful businesses at highly attractive prices. While profits are realised during bull markets, it is the investment decisions made during the bear markets that ultimately bring superlative returns.
We work hardest during the bear market, analysing as many companies as possible to find the best investment opportunities. Managing liabilities is also key in these markets. Bear markets can last years, and many overoptimistic investors have been “stopped out” of the market despite being correctly positioned, due to poor management of their funding sources. (for example, by being margin called or facing investor redemptions). Bear markets are a time to bunker down, buy what you can afford, make sure you don’t get stopped out and wait.
Taking the Temperature
So we see that an investor’s posture and behavior should be very different depending on whether we are in a bull market or a bear market. Hence it is important to regularly analyse market data and the behaviour of market participants in order to identify where in the cycle we are. Howard Marks calls this “Taking the temperature” of the market. A metaphor we also like.
Regularly taking the temperature of the market is key as sentiment shifts can be sudden and sharp. We consider the following when doing this:
Market Data. In particular turnover.
The sentiment in the financial press
Social Media sentiment. (Particularly twitter)
Anecdotal behaviour of market participants
How excited are the stock brokers?
How much retail activity is in the market?
How much interest is there in the market during the dinner parties of Colombo?
Have the dentists started buying shares?
In a companion blog post to this article we will walk through our observations of the Colombo Stock Exchange in December 2024, as we take its temperature and talk through our decisions in that context.
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