Understanding Sensex moves: When will Sensex top out? Look for signs in IPOs & investor portfolios

Gautam Baid, US-based portfolio manager and investor, says bull markets are typically fuelled by cheap liquidity, and usually come to an end when there is a spike in interest rates.

In his recently released book
The Joys of Compounding, published by HarperCollins, Baid describes the three stages of a bull market. In the first stage, he says, most people are skeptical about the rally. As stock prices go up for a while, acceptance from market participants gradually happens in the second stage of the rally. The end nears in the third stage, when most people turn ecstatic believing everything will go up forever.

So, how do you identify in which stage the Sensex is right now after the unimaginable rally to lifetime record highs in the pandemic-ravaged year? Baid says there are two indicators – IPOs and the quality of investor portfolios.

IPOs: Initial public offerings (IPOs) are an effective indicator of market sentiment. During Stage 1, good companies come out with IPOs at cheap valuations. During Stage 2, good companies come out with IPOs at expensive valuations.

And during Stage 3, bad companies (many of which do not even have any earnings) come out with IPOs at ludicrous valuations and still are heavily oversubscribed by retail investors, whose surging presence in the market become a late cycle indicator, Baid writes in the guidebook on value investing.

Very high levels of margin funding in the primary and secondary markets is a predominant characteristic of the final blowout phase of a bull market, during which the already overvalued stock prices of sectoral leaders of the bull market go parabolic and double or treble in a matter of a few months, to a point at which their absurd valuations can no longer be justified even by the greatest use of any imagination.

After this point, a bear market ensues, during which time common stocks are returned to their rightful long-term owners, he says.

Quality of investor portfolios
The quality of investor portfolios can also give signals about an impending bear phase in the stock market.

“As a bull market matures, many investors tend to move their portfolios from high-quality stocks with steady growth and high return on equity to cheaper but faster growing stocks with poor management quality and inferior return ratios, and then to commodities and cyclicals, and then to turnaround situations that are currently loss making, and then to microcaps with limited track record of operations, and finally to highly leveraged companies with projections of rapid revenue growth,” says the value investor.

At this point, the bull market usually tops out, and at the end of the euphoric phase, most investor portfolios have only junk left in them.

“During the bear market that follows, both quality and junk stocks fall hard. The former eventually bounce back in the subsequent recovery, whereas the latter stay low for many years, until the next bull run takes over,” Baid said.

Most definitions of bull markets are subjective as they do not talk about a predefined valuation target. A full-blown bear market, on the other hand, is generally preceded by a vertical market rise of significant proportions.

“A big bear market needs to be preceded by complete euphoria, a major unexpected negative dislocation, and a complete drying up of liquidity,” says the author.