The latecomer's guide to riding the market rally

Entering at the last phase of a rally? A staggered stop-loss will help

It's an axiom that major market rallies tend to be led by the stocks and sectors which had the worst performance in the previous phase. The sectors which have been great performers during the previous phase often tend to perform badly as well.

This pattern seems to be holding up in the current phase. The overall market has moved up by about 9 per cent in the past month.  The sectors with the highest returns include realty, PSU banks, energy, metals and Infrastructure. Realty is up 37 per cent, PSU banks are up by over 33 per cent while metals is up 21 per cent, energy is up 19 per cent and infrastructure is up 18 per cent.  The three sectors with the worst performance are FMCG, pharma and IT - these three industries with their array of blue-chips have negative returns in the past month.

The entire set of moves across the broad economy, and also in specific sectors, appears to be based on hopes of turnarounds, rather than on current performances. The last fiscal did not see very inspiring results across specific sectors and the projections for the immediate future are not very optimistic either.

Earnings growth was poor in general through 2013-14. In fact, IT and pharma - two sectors which have lost ground - had done reasonably well on the basis of a weaker rupee. There are no projections of a massive earnings jump across specific sectors. Nor is the global economy suddenly headed into a sweet spot - while the global recovery continues, it is gradual.

However, the possibility that the new government will be able to turn things around has already meant a positive boost to sentiment. This is not insignificant. Better sentiment usually translates into stronger consumption and that, in itself, could add considerably to GDP growth. If it translates into higher investments, that would be a bonus as well.

The rupee has rebounded but this is connected to the change in sentiment. FIIs have bought heavily through the past five months, pushing the dollar lower. This is one justification for the sell-offs  in pharma and IT.  

What is visible as of this moment is a string of companies registering 52-week highs without much in the way of fundamental justifications for the prices being driven up. In some cases, the hopes appear reasonable. For example, strong consumption patterns could push the automobile industry out of its long demand slump and so, there is a logical case for buying into auto stocks. But earnings projections and industry data don't back that story up yet.

In some cases, the hopes appear quite unreasonable. There is little chance of sustained reforms across the energy sector in both oil and gas and in power. Reforms may occur but they will be partial and they will benefit specific segments of the value chain. For example, primary producers gain if the price of crude drops. But refiners lose.

Also, in finance and realty, the RBI's input will be at least as important as the government and rumours of big rate cuts appear to be mere hype. The inflation data are not conducive to the central bank getting liberal with the money supply, especially if the monsoon is below normal.

Still, it is impossible to tell how long this trend could last. It is also impossible to set targets on the upside. It could be foolish to sell out into a rally that could continue indefinitely. In fact, more money could easily come into the market and sustain this trend.

As I have pointed out earlier, domestic institutions have been net equity sellers though the past several months. In fact, they have prevented the market from rising even more steeply because they have sold into every FII-driven rally. If the DIIs turn positive on the Indian economy now, there could be another burst of massive buying.

The danger for a retail investor is that he or she will enter in the last phases of a rally. One way to reduce damage in such cases is to have stop losses. Another is to have valuation cut-offs. A staggered stop loss can be helpful. An investor who decides he will sell, say, 5 per cent of holdings on a 10 per cent fall, and another 10 per cent if the price falls 20 per cent, etc, is not going to lose too much if there's a big crash.

An investor, who stops buying when the PE-growth ratio hits two or more is also going to face moderate damage. These cut-off numbers are off-the-cuff examples. Each investor has to determine his own risk appetite and set cut-offs accordingly.