As mentioned in the companion post to this article, it is key to “take the temperature” of the market regularly to know whether we are in a bull or bear market, and hence adjust our behavior accordingly. In this article I will run through some of our observations above the Colombo Stock Exchange as at December 2024 and how that affects our behaviour.
Quantitative Observations
A Strong and Sustained Price Rise
The CSE ASPI broke through its previous all time high of 13,500 on December 5th and continued to increase every single day, logging a record long streak of 23 consecutive green days. Since its trough on September 12 2024, the CSE has generated a 47% return. Several stocks would have generated significantly higher returns as 47% is the average index return.
Trading Data Shows Clear Evidence of a Bull Market
Below we compare the trading data of the market on the 26th of December with the 12th of September 2024, the last day of the previous downtrend.
Date | 12 September 2024 | 26 December 2024 | 5 year average |
5 day average turnover | 1,015,681,451 | 8,003,420,360 | 2,493,797,700 |
5 day average Trades per day | 7,585 | 44,942 | 19,006 |
3 month market return | -15% | +32% | 9% |
Despite only being three months apart, we can clearly see massive differences in market activity. To us it is clear that this market activity correspond with the signs of a bull market (high turnover, high trade volumes, high returns). In fact the trading data is some of the strongest we have seen. This is particularly remarkable given these high trading volumes occurred over the Christmas period which is usually a period of very low activity.
Qualitative Discussions Also Appear Bullish
There are regular articles in the media about the strong momentum in the stock market and we have observed Twitter chatter to also be very bullish. There are also reports of a pipeline of IPOs coming up. These are all signs of a bullish market.
However, we feel that the qualitative optimism is of a lower magnitude than that seen in previous market cycles at this moment. We suspect a lot of “part time” market participants have not yet got fully into the market, many being caught off guard by the sharp rise and possibly being distracted by the Christmas season. It does not yet feel like we are at peak mania where the dentist has gone all in a single stock with maximum margin.
Why are Markets so Bullish?
So we can clearly see a shift in market sentiment in the last three months. This sentiment shift was also clearly triggered by the peaceful conclusion of our presidential and parliamentary elections. We believe that there are multiple narratives driving this bull market.
A significant reduction in interest rates have made equity returns more attractive. (Especially due to much more favourable tax rates on capital gains and dividends)
Lower rates also encourage buying on margin.
The peaceful conclusion of the election along with a strong mandate given to the NPP have made investors more optimistic about government policy execution.
The NPP have made clear that they will continue with economic reforms, a key area of concern for investors. Despite being a left leaning party, their economic policies have so far been market friendly.
Sri Lanka made significant progress with its external debt restructuring, culminating in its successful conclusion in December along with multiple ratings upgrades.
Economic data continues to be positive with no near term risks on the horizon.
There is an expectation that the local consumer will show a significant recovery next year as tax cuts combine with economic recovery to drive consumption.
It is believed that the above consumption growth will lead to high corporate profits for the year ahead.
Unlike in the previous 2022 bull market, we feel most of the above reasons for optimism are justified. However, Sri Lanka has an unfortunate habit of grabbing defeat from the jaws of victory. We also live in a world with a very high risk of black swans (both global and local). Hence while the near term may appear rosy, it is important to always be cautious. We fear that if this level of optimism continues to escalate into euphoria, investors will be poorly placed to absorb any unforeseeable risks.
Speculation Increases Risk
As an aside, we believe (but are not completely sure yet) that most of the above high levels of market activity are being done by the more speculative participants. Low levels of foreign participation and institutional investor interest suggest most of this move is by retail and high net worth investors. High speculative activity generally increases the risk in the market as most of these participants have a shorter term horizon often lack the holding power to hold an investment through economic turmoil. They are also often on margin, increasing the risk of margin calls amplifying any downtrend.
Hence as speculative activity increases, market volatility increases, both to the upside but also to the downside. This further justifies our view that bull markets are a period requiring extra caution.
What about Valuations
We are not top down investors or sentiment traders. While we like to take the temperature of the market and use that in our decision making, our north star will always be our view on stock specific valuation. Our strategy is simple. If a specific share in a well managed company with good economics is trading below its fair value, we will own it. If the share is overvalued we will sell it. We will hence try to build and hold a portfolio undervalued shares of well run businesses.
The 47% gain in markets over the last three months have meant many of our shares are no longer as undervalued as they were in September. When a share appreciates, its further upside is lower, and potential downside is higher. Hence in our view shares are significantly less attractive than they were in September. However, we feel they are not yet in the bubble territory and the risk reward of being invested over the long term remains attractive.
Proceeding with Caution
As stated before, several factors convinced us to take the exceptional step of adopting leverage in our portfolio around six months ago. This was primarily driven by:
Significantly lower debt interest costs (especially after tax)
Very low valuations and attractive dividend yields
The clear signs of a bear market (in particular low interest in the market, low turnover, low retail activity and so on).
However, we feel the above factors are no longer holding as strongly. While valuations are still attractive, they are not as low as before. We are also clearly in a bull market with the resulting increase in risk. Hence we have been clearing out our leverage and moving to a slightly cash positive position. As valuations remain attractive and the bull market is supported by a positive economic outlook, we are “proceeding with caution”. We have also been using this period of high liquidity to exit “mistakes” and make minor portfolio rebalances.
We are also watching carefully for signs of bubble like valuations, at which point we will begin to more aggressively take profit and build cash. We think this period could be soon, but we will use valuation as our north star when making this decision.
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