Performance is Seasonal
A lot of time is spent on figuring out which stock or sector will do well over the next few months or years. However for the analysis to turn into performance we often need much more than the fundamental factors falling into place.
One of the key ingredients which is often not paid a lot of attention to but is likely responsible for atleast 50% of the performance is the market environment. If the market environment is good then you will have to be extremely unlucky to not make money. If the market environment is bad then you must be extremely skilled to make money inspite of it.
“There is always a bull market somewhere. Look for it.”
Capital has an inherent tendency to always chase bull markets.In other words, in order to have a high probability of making money energy is better spent in identifying where the market environment is conducive for making money.
Of course a lot of value investors cherish bad market environments to pick up stocks but the point i am trying to make here is that money is only made when the environment turns good. If the environment doesn’t turn good for long we say
“Markets can remain irrational for longer than we can remain solvent.”
But how do we figure out if the market environment is good, bad or ugly?
A simple metric is what trend followers typically use. Pick a few broad market indices. In our case let’s take Nifty 50, Nifty 500, Nifty MidCap100 and Nifty SmallCap100.
Now look at the trends in the 50, 100 and 200 EMAs and where the price is with respect to these EMAs.
A simple rule of thumb is if all the indices you have chosen are above the 50 EMA and and the 50 EMA is above the 100 EMA and the 100 EMA is above the 200 EMA - you can be fairly certain that you are operating in a good environment. When one or more of this fails you can calibrate your positions accordingly. You will encounter several permutations and combinations of these and hence it’s important to understand the context and then come to a conclusion.
Sometimes only the Nifty 50 will qualify but the mid and small cap indices will be all over the place. This typically means only the large caps are operating in a favourable environment and that is where you should probably focus more. This happened between 2018-2020.
This can also be used to look at sectors and understand if they are operating in a good or bad environment.
Trend followers use these for individual stocks too but often with stocks they work as lagging indicators and not as potent as when you use them on a set of indices to gauge the broad operating environment. Also for stocks in a good environment more than 80% of the stocks will qualify these and hence the usefulness as a stock picking tool is extremely limited.
Another way to use this as a signal in your analysis is when the deviations of the prices for the said indices vs the EMAs are extreme either on the down-side or upside - this typically triggers a bout of mean-reversion. This typically shows up as an almost vertical rise or almost vertical fall on the charts. When the readings hit the extremes be prepared for a snapback into the means.
There are other softer/qualitative factors that allow us to make sense of the market environment but the simple rule of thumb does a decent job and is quite useful to calibrate our exposures.
All in all, an understanding of the market environment is another tool in your toolkit to make sense of markets.