8 lessons from bull and bear stock markets that investors have learned over the past 2 years

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The current sell-off in Nepal’s only stock market, the Nepal Stock Exchange (NEPSE) and global equities reflects the risk of inflation, recession and global spillover. Naive traders who considered themselves invincible during the bull run either scared or held back on their trades. The recent Nepal bull market was filled with excessive speculation, manipulation, risk taking, naivety, free lunch mentality and investment decisions based on irrational assumptions.

Eventually, the central bank, Nepal Rastra Bank, ended the bullish party after its decision to limit margin lending led to market liquidity drying up. Therefore, it is better to recognize the lessons that the stock market has taught us over the past two years before investing in it.

Here are some of the few lessons investors should learn from the recent bull and bear market that we have witnessed in a short period of two and a half years:

1. Markets are cyclical, mainly driven by interest rates, liquidity and inflation

Stock markets go through a cycle, and the length of the cycle is unpredictable. Interest rates and liquidity are the main drivers of the market cycle. High liquidity and low interest rates are fueling rising asset prices. Low liquidity and high interest rates are holding down asset prices. How is inflation related to interest rates, then?

In a stagnant economy with low inflation, the central bank eases its monetary policy, which means it lowers its interest rate. Conversely, when the economy faces high inflation with or without growth, the central bank tightens its monetary policy by increasing its interest rate. The historic bubble and crash in global equity markets resulted from high liquidity and a sudden withdrawal of cash.

Remember when the daily turnover of NEPSE at the top of the market was 20 billion rupees and the sudden changes in margin lending regulations triggered a sudden withdrawal of liquidity and the downward trend. The recent bullish and bearish trends in the Nepalese stock market have proven once again that liquidity is a key driver of market cycles. The global market went into freefall after reassessing that inflation, which they thought was transitory, is here to stay for a while and expect aggressive rate hikes.

2. Greed, fear and narratives drive markets, and they are changing

Stock markets are rarely neutral and mostly sit on the extremes of fear and greed, resulting in market cycle and volatility. You may have short-term gains from following the trend, but huge investment gains result from going against the trend. Warren Buffet says, “Be fearful when others are greedy and be greedy when others are fearful.”

The stories in a stock market determine its performance. Have you taken any investment actions based on public opinion? Well, you’ve made a decision based on the market narrative. The stories are subject to whimsical changes and can last anywhere from a few months to a decade. The narratives are sometimes supported by fundamentals and sometimes irrational. As an investor, you have to differentiate whether the market narrative is sane or nonsense.

3. Your stock market tip from a friend and social media experts only lasts until the momentum lasts

It would be best not to confuse luck with expertise while investing in a stock market. Replicating your friend’s trade or making investment decisions based on a stock market tip may be the result of pure chance, not their expertise. Don’t invest based on social media market pundits who speak out or make bold claims to please the market. Do due diligence on the expert, such as their qualification and experience. Beware of those experts who give you advice for free. Remember that if the service or product is free, you are the product.

4. You cannot rule the market based on rumors and market advice

There is no free lunch. Investors seeking stock market advice and acting on rumors were commonplace and are still prevalent today. Most investors seeking stock market advice are at the bottom of the pyramid. Stock prices have already priced the rumor or anticipated event, as the top of the pyramid has already taken investment action based on it. For example, you receive a stock tip that a company will pay a stock dividend for the first time since its inception, persuading you to trade on the tip. You don’t realize that the top of the pyramid got the tip before you, probably buying stocks aggressively, which drove stocks higher and priced the event early. Even if you act knowing this, you are speculating that someone else will buy the stock tip.

5. Markets don’t necessarily need to move with the economy

When the coronavirus emerged, it was clear that businesses and the economy were heading into lockdown and losing revenue. If there was an efficient market scenario, NEPSE should have refused to reflect this uncertainty. Instead, excess liquidity and huge amateur retail investor interest in the stock market out of boredom, herd mentality and irrational exuberance sparked the bull run.

Nepal Stock Exchange (NEPSE), the only stock exchange or share market in Nepal
Nepal Stock Exchange (NEPSE), the only stock exchange in Nepal

6. Relative valuation works as long as the market is correctly priced

The price-earnings ratio and other relative valuations are widely used for their simplicity. However, they are subject to income manipulation and the market cycle. Consider valuing a stock based on industry peers when the market is at the top and the industry itself is overvalued. You will always find undervalued stocks based on comparable methods. Do you think your investment decision based on the comparative way to the top of the stock market is justified? Also, consider that if you don’t adjust earnings for one-time earnings such as gain on sale of assets, your earnings per share are skewed upwards.

7. You can’t build a castle in the air.

The fair value of a stock is to avoid the value of future cash flows. Over the long term, stocks are driven by their fundamentals and outlook. In the short term, stocks with poor fundamentals and prospects can trade at exorbitant prices. Simply put, a price to earnings ratio of 30 means it would take 30 years to recoup your investment if the company has no earnings growth.

Consider hydro stocks with no additional project trading above a price-earnings ratio of 35. Since hydro companies have a maximum license term of 35 years, hydro stocks trading above the PE of 35 involve that the market expects hydroelectric companies to generate electricity. beyond their license period, which is unwise.

8. Your enemy is your prejudices

All great stock market investors are aware of their biases, both cognitive and emotional. It’s not that they don’t; they reflect on them and correct them when they realize they have emotional biases. And they are either lifelong learners or refrain from investing in actions they don’t understand to minimize their cognitive biases. Some biases are illusion of control, overconfidence, regret aversion, loss aversion, mental accounting, anchoring, hindsight bias, confirmation bias, framing bias and representative bias.

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