Nifty at record high: How to navigate challenges in a surging bull market

As long-only investors, the allure of a surging bull market is undeniable. The thrill of surging stock prices is not only in witnessing sky-rocketing portfolio returns, but also in getting the vindication in the underlying investment theses. Who wouldn’t welcome the excitement of a bull market? However, there’s a catch.

While it’s a common tendency to view downcycles as emotionally draining experience, the same emotional complexity often gets oversimplified or outrightly ignored when it comes to upcycles. The prevailing notion is that the upcycles are a gloriously gleeful ride, but this perspective can be deceiving. The truth is, upcycles are equally challenging. The psychological dynamics at play during a bull market are intricate. While FOMO is at full display for those waiting on the fence during bull markets, for the fully invested ones, completely different dynamics come into play. The most prominent among them are the fear of selling early or the tendency to hold on to the winners for too long, blinded by the influence of the recency bias because of which the objectivity gets clouded by the recent performance of the stock. Greed and regret aversion are dominant biases during bull market that deter seasoned investors from acting rationally and objectively.

No one doubts the extent of nerve required to continue buying actions on falling markets. However, on the flip side, investors tend to underestimate the emotional skill required to do selling actions on a rising market. Here is the point. While it is a well acknowledged fact that one needs to have an unnerving stomach to digest losses (notional though) in a down-trending market to be reasonably successful in investing, a similar strength needed in the rising markets to leave potential gains on the table by not yielding to regret-aversion bias is relatively overlooked by many. In rising markets, the fear of missing out on potential gains (greed) and the fear of regret (selling too early) can prevent investors from selling when it’s rational to do so.

Let us explain this with examples. But before that, a bit about overshooting and undershooting that drive the markets to extreme swings during tops and bottoms.

Markets are not a rational beast that trade at fair value. They rarely trade at fair value, undershooting and overshooting around fair value all the time. The only thing is the level of such swings is extreme during the depressing bear markets or during roaring bull markets. In both these extremes, investors need extra nerve to do contra actions as any such actions would seem like a huge mistake in the short term given the markets’ sharp acceleration in either direction. That applies to both buying actions during the bear market and selling actions during bull market.

Now turning to examples, in a typical portfolio position, stock goes through a derating cycle when the earnings hit the bump or soft patch. It normally lasts for a few quarters to few years depending on the depth of the earnings cycle. When the earnings recover, it triggers the rerating cycle for the stock. The best value or the maximum mispricing happens when an earnings bump coincides with sharp market drawdowns, leading to a huge under-shoot in the underlying stock price. Similarly, the best overshoot appears when the earning recovery cycle coincides with the sharp upturn in the general market cycle. In either of these extremes, it is hard to time the top or the bottom for the stock prices.

In a surging bull market, when exit is made at a rational price, stock may continue to go up because of the underlying overshooting in the stock price. The exit decision may appear to be a mistake in the short term but may turn out to be right in hindsight when sanity returns to the markets. Money managers can relate to this in the ongoing bull market, where many positions have continued to rally by 40/50% after exit was made at 5 to 10X returns. It is natural for money managers to slow down their selling action when they see markets rewarding inaction, but it will be precisely wrong thing to do from the perspective of long-term portfolio performance. This skill (or the nerve) to digest notional losses from probable up move after one fully exits is the key determinant that would separate men from boys. It would be suicidal to underestimate or overlook this skill as this can make a huge difference to the eventual alpha creation in the underlying portfolio.In the current scenario, the Indian markets appear to be riding a wave of optimism, with a perception that nothing can go wrong. However, it is during such seemingly bullish times that unforeseen risks can emerge, going by experience from past cycles. Unfortunately, the true nature of such risks often becomes apparent only in hindsight. Given this, it is no harm to exercise a bit of caution and to continue to raise cash levels at the portfolio level incrementally (pruning in a phased manner in a stock-specific basis in over-extended positions) in the portfolio without yielding to the temptation of inaction which the markets seem to be rewarding at the moment. Even though this decision may appear as a mistake in the short term because of the markets’ acceleration in one way, we are fairly confident that when one looks back, this would have proved to be the most prudent decision in hindsight.

(The author, ArunaGiri N, is Founder CEO & Fund Manager, TrustLine Holdings)