Tuesday, September 01, 2009

Should I Go Against The Market?

AS the stock market continues to move higher, a lot of investors are wondering when it will come down again. Those who have been involved in futures trading may be tempted to short the KL Composite Index (KLCI) futures contracts.

Unfortunately, each time they start shorting the index, the market surges even higher and touches a new high. As a result, they are forced to cover their short positions as the market turns against them. In this article, we will look at how to apply contrarian strategies in the present market conditions.

Contrarian strategy 1: only correct when the market turns around

Investors need to be careful when using contrarian strategies. These strategies are only effective when the market starts to turn around, otherwise, investors will end up being wrong.

Contrarian investors feel that most people in the market tend to get carried away by the market sentiment, so if they keep calm, they will have a better position by taking actions that are the opposite of what others are doing. They believe that they can make big money by betting against popular investment trends.

In the current stock market situation, even though the average daily-trading volume is about one billion shares, we notice that there are not many retail investors. The market is mainly filled with some big fund managers or day traders. Some investors who managed to catch stocks at cheaper prices may have been selling most of their holdings lately.

Unfortunately, the market continues to trade higher than previous selling prices. In such situation, the worst mistake for some retail investors is to abandon their contrarian strategies and start buying back the shares that they disposed off earlier at even higher prices.

Normally, when everyone starts to think that the stock market will continue to go up, that is the signal of an impending market crash. Hence, investors need to be patient to wait for the right prices before buying back those stocks.

There is also the danger that some investors may start accumulating their stocks too early. We believe that “the panic may be over, but not the crisis”. Even though there are signs that the overall economy may be on its way to recovery, we think it will take some time before we can see the real recovery of the stock market.

We need to understand that once the fund managers feel that the stock prices are far above the fundamental of the stocks, they may stop accumulating stocks.

As a result, due to a lack of demand, the market may start dipping lower again with dwindling trading volumes. It may take a long time before the market turns higher again.

We saw this phenomenon in 2000-2001 when the market dipped slowly with very thin volume for a 15-month period, with the KLCI tumbling from about 1,000-level in February 2000 to 550-level in May 2001, a total decline of about 45%.

Investors need to take note that unless they have deep pockets to average down their purchase prices over a long period, they may run out of funds before the market reaches the bottom.

One way to avoid accumulating stocks too early is by adopting the filter rule strategy proposed by Alexander (1961). He proposed that we should only buy stocks when the market touches the lowest point and starts recovering for k% from its low and sell stocks when the market discovers the peak and starts falling for k% from its high.

This strategy may reduce the feeling of regret from selling stocks too early. Given that we may never know when the market touches its peak, it may be a good strategy to let the market find the top and only start selling when the market confirms the declining trends.

Contrarian Strategy 2: Buying neglected firms

Recently, as the result of the merger between main and second board companies into the Main Market, we notice that some second board companies, which have good fundamentals but previously lacked analysts’ coverage, are starting to get the attention of investors.

We believe these companies may provide good buying opportunities for investors who have missed out on the opportunities of accumulating blue chip stocks at cheap prices. Some academic studies have shown that the returns from buying neglected firms, over a long-term period, may be better than investing in “popular” companies.

Personal Investing - By Ooi Kok Hwa

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