Stock markets pay for getting market tops and bottoms right

Vikas SinghaniaTrade Smart OnlineIn case if you have been around in the stock market for some years, the most common free advice that is available is to buy low and sell high or, it would be sell high and buy low (making money by shorting). There is nothing wrong in this advice. But the problem comes when someone asks how we can identify a top or a bottom. In a steady uptrend what looks like a top could be a temporary consolidation with the market moving in the same direction after a small break and same is the case in a downtrend. Markets can remain irrational longer than you can remain solvent, is another adage which tells you that market study is not a perfect science. It is very difficult, if not impossible to predict the market top and bottom, consistently. It is in search of these peaks and bottoms that we see many an investor lose their capital and much more. Though the exact reversal cannot be exactly predicted on a consistent basis there are enough indicators, both fundamental and technical, which gives us a clear indication of a likelihood of a reversal. Let’s tackle the fundamental type first. Equities as an asset class compete to attract money vis-à-vis other asset classes like bonds, commodities, gold, currencies among others. Though the risk is among the highest in equity, investing in equities is easier as risk is measurable by straight forward data points as compared to, say commodities or currencies.Generally market participants keep a track of price to earnings (PE) ratio of individual stocks as well as the market to get an idea of where it trades in the historical band. Take in the case our BSE Sensex, an idea that a market top is close by can be found if the PE ratio is around the 30 mark. Similarly markets are nearing a bottom if the Sensex PE ratio is around 12-14 levels. The bottom PE of 12 is not just an arbitrary number - there is a reason why the market rebounds when the Sensex touches a PE of around 12. Inverse of PE is EP or the earnings to price ratio which is also called the market yield. Inverse of 12 is around 8.33 per cent which is also close to the risk free interest rate in the country. Thus when markets start moving around these levels, smart investors start moving their money from risk free assets to equity which is now available at the same yield as a risk free asset. Further equities offer a much better upside move as compared to a risk free asset. Many investors look at dividend yield to pick up stocks. Excluding special or one time dividends, quality stocks picked up offering a good dividend yield offer a good long term bet. Market bottoms are also identified by a complete lack of volume or interest in the markets. Market tops are when valuations are in the bubble zone, a number of companies are either raising money or placing their shares, or everyone wants to be a trader and offers you free advice. Technically speaking there are many indicators that inform us of a possible top or bottom. Tops will see very high volatility and the same time most of the oscillators will be in the over-bought zone. If higher volume does not able to push the market higher, it is an indication that there are more sellers in the market. It’s time to move your stop loss tighter. Very rarely are tops and bottoms made on a single day. They generally form a pattern which can be visible for the trained eye. Some of the most tracked patterns near the top and bottom formation are ‘Head and Shoulder’, ‘Double or triple tops and bottoms’, ‘Rounding Pattern’ among others. Many investors follow what is called the ‘Golden Cross’ and the ‘Death Cross’, these are exactly opposite indicators and easier to locate. The cross occurs when the short term moving average cross the long term one. Some define the short term moving average as 50 days while others define it as 100 days. The long term moving average however stays at the 200 mark. When the short term moving average crosses the long term moving average from below, it is an indication of market entering a bull phase or a ‘Golden Cross’ has taken place. Similarly if the short term moving average crosses the long term one from top we are in a bearish phase or a ‘Death Cross’ has occurred. Irrespective of whichever method is used an investor should know which way the market is going. Has a top already been established or is there more room for the market to move to establish a top. Similarly in case of a bottom he will have to be patient as markets generally take a lot of time to move higher after making a major bottom. Even knowing that we are close to the top and bottom is good enough to trade the juicy middle section of the market.