Taking Advantage of Market Gyrations
Who would have guessed a year ago, with American troops newly embroiled in combat in Iraq and the outbreak of SARS in Asia, that the Stock Exchange of Thailand (SET) was about to log one of its best years ever? However, during the first 2 months of 2004 sentiments seem to be in reverse with an outbreak of a different kind of epidemic. If you are one of those people who are frightened by the markets' volatile nature of late, we will show you in this column how to take advantage of it.
I don't want to dampen anyone's optimism over the 116% gains from the SET last year, which have been a long time in coming. After all it's been almost 7 years since the Asian crisis erupted. In fact I was as delighted with the rally as anyone. It vindicated my belief in the market over the long term, not to mention my repeated advice to dollar cost average stocks when they were in free fall. A good number of you, myself included, paid dearly for the 85% decline in the SET Index from 1997 to 2001. Personally, I don't think anything nearly that bad is imminent now. But if you believe in the “revision to the mean” theory, which predicts that over time the overall market will return to its historical average gain of about 12% per year, then last year triple digits return will eventually lead to another abnormal decline.
Now that the market has more or less priced in the full impact of the “birds' flu” this is a good way to gauge your own tolerance for volatility. Kindly note that I didn't use the word “risk”. It is important that you do not confuse volatility- the short-term gyrations of stock prices with the risk of loss. When a company goes bankrupt, then you loose everything just like in 1997. That's what we call risk . But if a company's stock price gyrates like a yo-yo, it"s called volatility.
Volatility should be meaningless to the long-term investor. This is particularly true for younger investors, and by younger I mean anyone with a 20-year investment horizon. However, not all of us are strictly rational, myself included. Like everyone else, I must confess that I didn't enjoyed the bear market, especially the worst months of it. I berated myself for not having sold more stocks when the Index was at 750 points and at the same time I tend to worry too much in a falling market even though my investment horizon is fairly long. In other words I behaved like plenty of other investors. However, I don't mean to brag but in key respects, I maintained a grip on my emotions and stuck to the disciplined investment approach of dollar cost averaging that I have outlined in M&W issue 4. I am one of those people that like to put my money where my mouth is.
Understanding Beta
One of the best ways to measure the likely volatility of your portfolio is to look at the beta for each of your stocks, a yardstick that many investors ignore. Simply put, beta is a ratio that compares the historical volatility of a particular stock with the volatility of the market as a whole. A beta greater than 1 indicates that a stock is more volatile than a particular benchmark, in our case it's the SET Index; a beta ratio of 2 is twice as volatile. Conversely, a ratio of less than 1 is less volatile; a ratio of 0.5 is half as volatile. In fact, a few stocks actually have negative beta ratios, which means their prices move inversely to the market. Betas for any stock are available at most brokers' research web sites but the one I find particularly useful is www.thaiset.com
Why do some stocks have such high betas? Historically, it's because their stock prices have gyrated significantly, which begs the question of why their prices move so much. This may reflect that their earnings have risen and fallen dramatically, as in the case of many cyclical stocks. But it is also because of factors that aren't related to fundamentals at all. As you can see from the table below, the highest beta stocks on the SET are warrants of companies whose earnings expectations, both positive and negative, often become out of line with reality. Not forgetting that, the “gearing” of warrants tend to exacerbate the price gyrations even further. Furthermore, high beta stocks tend to attract speculators and manipulators, who drive prices up and down with little regard for economic fundamentals. In this sense, a high beta becomes self-fulfilling.
At the top of the high beta list is SCB-W, with a beta of 2.65. but there are plenty of established names betas of over 1, including K-Bank, LPN, CK and SATTEL. Please see table 1.
Trading Strategies
Once I have determined my asset allocation, I am one of those rare people that love to “buy and hold” and as a result this strategy has served me very well over the years. For example 80% of my portfolio is in equity and no matter what the market does I remained invested through both bull and bear markets. However, I am not your typical investor. Most of us probably would like to engage in what is called “tactical asset allocation” meaning adding more stocks in the portfolio when the stock market is doing well and reduce equity exposure when the market is not so hot. This is where your knowledge of beta comes in. You can almost be sure that buying and selling opportunities will present themselves for high beta stocks more often than for their lower beta peers. And if you are buying high beta stocks for fundamental reasons, rather simply to speculate on price movement, and you turn out to be right, your returns will be enhanced. Therefore, instead of reducing your equity exposure in a bear market, try keeping the equity portion in your portfolio the same but “switch” from high beta stocks to some low beta stocks such as LH, POST, EGV will provide some useful stability during the bear market. But do not expect much excitement from these stocks. This trading strategy may not work out for all of you but it is worth giving it a try. So enjoy the current rally in the SET but be prepared for some turbulence. However, it is important to remember it's the end of your investment journey that counts, no matter how many ups and downs you experience along the way.