The Four Most Dangerous Words In Investing

"The four most dangerous words in investing are - this time it's different", investment Guru Sir John Templeton once declared famously.

Sir Templeton was no doubt a man who possessed a significant degree of good judgment about the stock markets, quite possibly accumulated through his many investing experiences over numerous market cycles.

Truth be told, every asset class does possess certain telltale signs that preclude steep, unnerving falls. The irony is that retail investors tend to brush aside the warning signs by declaring confidently, "this time it's different".

While this article isn't intended to scare retail investors away from the equity markets just yet, it is however meant to serve as a cautionary note to those who, buoyed by euphoria and armed with a little knowledge, are rushing in hook line and sinker into equities.

Say 'Hello' to Mr. Market
Benjamin Graham (none other than Warren Buffet's Guru) described Mr. Market as an individual who is usually willing to underpay or overpay for your stocks, but very rarely pay the right price. This is the most important definition of the equity markets that retail investors need to know.

Another important point - while the smaller time technical analysts and pundits appear on TV and confidently declare which direction the markets are going to take next, it is the great masters of investing who resign themselves to the fact that it's really quite impossible to predict precisely when the markets will take a massive swing for the better or worse.

Remember this: as a retail investor, asset allocation is of paramount importance - far more relevant than timing entries or exits. In other words, you need to have the ability to classify current market levels as undervalued, moderately valued, or overvalued - and adjust your split between stocks and bonds (equities and debt) accordingly.

Frequent and disciplined rebalancing will safeguard you against the risk of getting caught into one of those nightmarish market falls that have scared scores of investors away from the markets forever.

Equity market dynamics - simplified
Have you ever wondered - what are stock prices, really? And what justifies an increase in these stock prices? Say, a company is valued at Rs. 1000 Crores today. What would justify an increase in the valuation of that company to, say Rs. 1200 Crores (a 20 per cent increase in its stock price).
The simple answer is - earnings growth. That is, a company becomes more valuable when it's profits after taxes go up over and above the previously measured benchmark.

It doesn't quite work that way in real life, where the collective emotions of millions of investors and speculators determine stock prices in the near term. Buying frenzies can and do push stock prices well over fair value, and vice versa.

The fascinating truth is that markets are always subject to the principle of 'mean reversion', that is - they will oscillate between being overvalued and undervalued, with a strong tendency to revert to the mean (fair value) at periodic intervals.

Four signs of an impending correction
Returning once again to Sir Templeton's profoundly simple comment on the markets, it's clear as day that there are some very telltale signs of an impending stock market correction. While the extent of the correction (a 20 per cent drop or a deep 50 per cent cut) isn't fathomable, prior knowledge of these signs can help prudent investors rebalance their portfolios and enter the safe zone if need be.

First (trite as it may sound), watch out for the current P/E ratio of the benchmark index - the NIFTY, in our case. Any number above 25X should set off warning bells - the market is pricing stocks (on average) at 25 times current earnings. Would you pay a lot more than Rs. 25,000 Crores for a large, bluechip company that's currently generating Rs. 1,000 Crores in annual profits after taxes?

Second, count the number of IPO's (initial public offerings) hitting the markets. Promoters who have worked hard to build out their businesses would like to get the maximum bang for their buck, and will therefore try to time their IPO's in a manner that they receive the highest possible valuation. Yes, often at the cost of unsuspecting retail investors - that is the unfortunate truth! A year when you see more than 75-80 IPO's succeeding is quite probably a year when you need to start becoming underweight into equities.

Third, watch out for retail inflows into equity mutual funds (It's probably wise to exclude the funds flowing in through Systematic Investment Plans from this number). It's a sad and painful truth that most retail inflows take place closer to market peaks. In other words, when your local 'paan-wala' starts giving you stock market tips, make sure you run for the hills and seek out safer fixed income asset classes!

Lastly, excessive groupthink is a classic indicator of a reverse trend. It may sound funny that the collective opinion of a group of so called experts is to be considered an indicator of the exact opposite, but that's precisely how things have always been. If the general sentiment is that "the NIFTY is due to scale new highs over the coming years", it may be time to rebalance your portfolio in favour of debt instruments.

So now, coming to the million (or billion?) dollar question: where do Indian equities figure when tested against the above model?

The trusty current NIFTY P/E stands at close to 24.5X as on date - up from around 20X at the start of the year. Prior to the crash of 2000, we were close to 25X and prior to the 2008 meltdown, closer to 28X.

Close to 60 IPO's have already hit the market this year, and with four months to go, we'll probably see this number rising to the late 80's by December.

Buoyed by retail inflows, Equity MF assets reached an all-time high of 4.16 Lac Crs in August.

And lastly - all you need to do is switch on any business news channel, and you'll quite likely be able to breathe in the collective optimism about the where the markets are heading in the next few years!

Now this surely doesn't indicate that we're on the brink of a massive meltdown. However- in light of the above, it may be wise to revisit your asset allocation and adopt a more cautious stance towards equities at this stage. Corporate earnings have some catching up to do, and you may like to wait for the famed mean reversion to kick in before you decide to sell your house and buy stocks "just because your friend made a killing in the markets recently".

Or you could choose to brush these signs aside and declare with elan - "this time it's different!". I wonder what Sir Templeton would have to say to that, though?