Consider your risk appetite when investing in equities

The question most investors ask these days is: Is it too late to invest in equities? The enthusiasm and optimism in the markets unnerve the investor who has just about recovered from a severe bear market. He is unwilling to join in despite the mood being so upbeat. How does one invest in a market like this one? There are three layers to the play of prices in equity markets. The obvious and evident layer is 'sentiment'. The more solid layer is the fundamentals of businesses. The overarching macro economic cycle is the deepest layer. 'Sentiment' is a loosely defined term on the street but, in reality, refers to the flow of money. However promising the prospects for a market may be, without liquidity to back it, the market will remain low.

The return of liquidity-driven buying interest in the market is almost always owed to leverage or borrowings. Speculators as well as a large number of investors do not stake their own money in stocks. They borrow to take a position.

When the markets move up, they make a disproportionate gain for the amount of money they have staked.

When markets begin to move up, and predictably post gains over sustained periods, borrowing is so worthwhile.

Lenders are also more than happy to take risks, since they have the collateral in the form of the equity shares being bought. They will adjust the interest rate or the margin (10% in the above case) depending on how the prices behave.

Almost all sharp increases in the price of assets, defying underlying fundamentals, can be attributed to leverage and the amount of liquidity it makes available to the market. The real estate and gold markets in India defy fundamentals systematically, since unaccounted, borrowed cash flows into it.

More funds are available to borrow when prices move up, and prices move up because more borrowed money is being funnelled into the market. And, sometimes, this takes on sinister proportions and leads to fraud.

This cycle is broken only when prices fall. When prices fall from 100 to 99 in the above example, the borrower repays the money but is left with a dent on his capital due to the loss. Lenders will not offer an open-ended source of funds. They will lend for short periods from a day to three days, going at the most to a week. This is because the lender will need so much more capital if lending is for longer periods. Lending for short periods means the same amount can be recycled once it is repaid. What we know in the market as profit-bookings are simply positions of borrowers who wind it up to repay the lender and take fresh positions. Margin lending by brokers works on the same principle, and is limited by the amount of money they are able to lend.

It is the second layer of business fundamentals that can arrest an unbridled increase in prices purely owed to the flow of funds through leveraged operations.

Stocks markets are not merely speculative dens for money to flow in and out, but also price discovery mechanisms for the fundamental value of a business.

There are also a large number of investors who take informed decisions on stocks, based on the prospects for future earnings of a business. It is the presence of these players that brings balance into the markets. When leveraged players take prices to unreal highs, these players may step in to sell and book out when they believe the stock is overvalued. Both global and domestic players include such informed investors who put a check on prices. Market cycles, driven by macro fundamentals, ensure that asset bubbles driven by borrowings are punctured either by increase in interest rates, or by drop in sales and profits of unsustainable businesses.

How should investors take their decision in the current markets? First, any market that corrects itself from time to time, is relatively safer than the one that only moves up every day . Every correction signifies there is no unlimited money behind the prices and, therefore, there is no fraud. It also means that leveraged players are being checked by unexpected fall in prices. Second, price is not an indicator of future prospects of a business.

Unless fundamental strength is evident, there is no point in buying only because prices have moved up. Investors will find the opportunity in the next few quarters as fundamental business information moves from negative to positive. This gap between price and fundamentals is a risk and an opportunity over the next few quarters. Third, a change in economic cycles is triggered by low interest rates, supported by macro-policies, and sustained by expanding businesses. This plays out over a long period of time.

Investors have all the three choices: borrow and punt to make money sometimes, or lose it sometimes; run with fundamentals and invest at every correction; or, shoot for the cyclical change and take a secular long position. Which one you choose will depend on how much money you have, how much risk you can take, and how long you can wait. Every equity story, as it turns out, is so much about what you can do rather than about what the market is doing.