Triggers for market timing

Sanjiv Shankaran

THE BSE Sensex currently hovers around 3250 points - about 47 per cent below its historic high. Is the equity market at the right level to start buying?

Yes, if the pattern of movement in the BSE Sensex over the last nine years can be used as a signal. Investing at a similar level in 1993 or 1998 would have resulted in a return of 40-60 per cent in the subsequent bull runs of 1994 and 1999-00 respectively.

Nine years of data may not be exhaustive, but they have witnessed two bull runs and three huge falls. Patterns repeat themselves in the equity market and, when correctly interpreted, are good indicators of changing trends. A study of the ups and downs over the period reveals recurring patterns. Interpreted in terms of magnitude of change, they present an opportunity to capitalise on the repeat of a pattern.

To illustrate, when the Sensex falls 45-50 per cent from an earlier historic high, there is a strong likelihood that the fall will soon be arrested and followed by a rise.

The best way to capitalise on the ups and downs in the Sensex movement is to invest in an index fund - one that blindly mimics the composition of an index. Thereby, the investment and the indicators for a change in trend are the same - that is, either the Sensex or the Nifty.

Identifying the triggers: Based on the patterns over a nine-year period, a few invest/sell triggers were identified. The percentage change in the Sensex determines the trigger for a buy or sell. The triggers are based on the assumption that certain patterns repeat themselves because investors usually overreact to most developments. Once sense dawns, a correction takes place. The process is then repeated, thereby throwing up identifiable patterns. The patterns offer an opportunity to second-guess index movements.

Using the patterns from April 1992 to November 2001, two approaches were taken on an imaginary investment portfolio. The idea was to use the triggers to enter and exit and see if it was profitable.

Simple strategy: In this case, the idea is to use a strategy that does not require constant monitoring and keeps transactions and associated costs to the minimum.

Based on the patterns, the right time to enter the equity market is when there is a 40-50 per cent drop from the previous peak. When the Sensex loses close to half the value of the last historic high, it seems a good time to invest in an index fund.

Once the investment is made, one has to sit tight till the Sensex reaches a new high and then look towards an exit. An exit may be made as soon as the Sensex reaches a new historic high or made in stages when a new high is reached. For instance, 50 per cent of the investment may be sold when a new high is reached. And then the balance sold if the Sensex moves another 10 per cent above the previous historic high.

Based on this trigger, an investment could have been initiated around April 1993, when the Sensex dropped to about half the value of the historic high registered the previous year.

Assuming that one sold when the Sensex peaked about 17 months later - September 1994 - an investment of Rs 1,000 would have given Rs 2,190 in about 17 months. That is, a return of about 69 per cent. The next opportunity to invest would have come around December 1996 or December 1998, when the Sensex lost a little over 40 per cent of its historic high of about 4,600 points.

Assuming one invested Rs 1,000 in December 1998 - the period when the Sensex was a little over 40 per cent below its historic peak - the best time to exit would have been about December 2000, when the initial investment would have doubled. This approach would have yielded a return of about 41 per cent.

Currently, when the Sensex has dropped to half the value of the historic high of February 2000, it may be time to invest again.

Drawbacks: The most obvious drawback is that one still has to use a bit of discretion in investing. For instance, the last nine years have shown that there is a great deal of resistance when the Sensex loses 40 per cent of the previous high. Sometimes, it loses up to 50 per cent and sometimes a little less. Therefore, one has to use discretion in committing money at a level that is 40-50 per cent lower.

Even when it is time to exit, some care has to be taken. Soon after the earlier historic high is reached, it is time to book profits. But there is a likelihood that earlier historic highs will be bettered by some distance. If so, one has to use discretion to exit. For example, a margin of 10 per cent above the previous high may be used as an exit trigger.

Repeated-entry strategy: A relatively passive strategy discussed earlier makes for moderate but safe returns. A more chancy way - though more lucrative too - would be to enter and exit frequently using pre-determined triggers.

The nine-year Sensex pattern indicates that it may be possible to time the entry and exit in the course of series of small ups and downs that are a part of the big trends _- that is, capitalise on the small waves that make up a big wave.

Assumptions: This method calls for regular monitoring. An investor has to gauge carefully the time when the overall trend has begun to change - when a decline is turning to a bull run, and vice-versa.There seems no way to predict the time taken to move from one trigger to the next. In other words, when an investment is made, there seems no way of being able to forecast when the next trigger will come.

The basic triggers used in the chancy strategy are wait for a 25 per cent decline from a high and then invest. Subsequently, wait for a 20 per cent appreciation of the investment prior to selling off.

As mentioned earlier it is important to recognise when a new trend is underway in order to exit completely or hold on even after the trigger is reached in order to capitalise on it.

Summing up: Academics never fail to point out that equities provide the best returns over the long term compared to other investment avenues such as corporate debentures and government securities. Equities are also the most volatile, thereby making it all the more important to time one's investment.

To illustrate, an investment made about eight years ago - August 1993 - and held till today (in an index fund) would yield little benefit because the Sensex is just a little higher than it was eight years ago. In the interim, we saw the Sensex touch almost twice the current value of about 3,250 and fall to lower levels. Unless one managed to time the initial investment and subsequent exit, equities would not have fetched meaningful returns.

The triggers identified are not fool-proof; nothing really is in the equity market. But based on nine-year data, they seem to provide reasonable pointers to a relatively safe way to profit from the ups and downs of the equity market.