There are several techniques to time the entry and exits. Let us discuss the broader parameters here and leave the complex ones for forthcoming issues.
For passive investors:
For investors unable to track the markets regularly, the best way to time the market is through what is called automatic rebalancing--having a proper asset allocation and sticking to it by rebalancing the portfolio regularly. Let us say you started investing in the beginning of 2008 with a 50% exposure in equity and 50% in debt. By the end of 2008, the equity portion fell by 50% (ie gone down from 50 to 25, while the debt has generated a return of 8% (ie gone up from 50 to 54), tilting your asset allocation in favour of debt. That warrants a rebalancing (i.e., moving back 15% from debt to equity). Likewise, the stock market rally in 2009 and 2010 made certain that your equity portion went past the 50% mark, necessitating a partial profit-booking and diverting it to debt.
Tweak the asset allocation depending on market valuation. The equity portions of the portfolio can be modified a little based on the overall market valuations. When following this strategy, the equity component of the portfolio will be defined as a range (say, 40%- 60%) instead of a specific percentage (50%). In the above example, the equity component can be increased to 60% if the Sensex P/E drops much below the historical average and is brought down to 40% if it goes much beyond the historical average. (See box on PE as investing signal)
For active investors:
Active investors who track the market regular can be classified into two types—those who believe in fundamentals of a stock and those who also look at the technical factors. Should fundamental investors ignore all market fluctuations? "No," says Warren Buffett, the legendary value investor. "Look at market fluctuations as your friend rather than your enemy; profit from market's folly rather than participate in it," he says.
The investment decision has to be directly linked to the valuation of stock (if you are investing in one stock) or valuation of the broader market (if you happen to have a diversified portfolio). The strategy is simple—make sure that the value you get is much more than the price you pay. There are several methods to arrive at the value of a stock such as the earning discount model, dividend discount model and discounted cash flow (DCF).
Investors also must compare the valuation of stocks by comparative valuation tools such as price-to-earnings ratio (P/E), price-to-book ratio (P/B), dividend yield, P/E-to-growth ratio (PEG), etc. We will explain these in forthcoming issues.
The decisions to be either 'in' or 'out' of the market themselves centre on timing, investors should take a call about the broader market valuation here. If you are a high risk-taker and ready to be in/out of the market for a reasonable period, you can use market valuations to balance your equity portfolio. The strategy here is to totally exit the market if valuations reach unsustainable levels.
How to arrive at broader market valuations? The best strategy is to calculate the forward P/E (i.e., value of the broader market index like Sensex by its estimated forward earnings). As a retail investor, it will be a difficult task.
Several brokerage houses and wealth managers offer this service and use their own assessment about market valuations to arrive at the required asset allocation. If you are doing it yourself, you can use the Sensex trailing P/E, which is calculated and is available in most financial papers and websites.
As is clear from the Sensex P/E box, the Sensex trailing P/E was moving in the range of 12 to 28 in the past 15 years. It can also be seen that the market went into a deeper correction once the valuation crossed the 28 mark — the same can be used as an exit point.
For 'technical' investors, technical analysis is a useful tool to time entry and exit. Since prices may move up or down 15% to 20% due to technical factors alone (i.e., without any change in fundamentals), use of technical analysis to decide the exact entry is useful.
Technical analysis is based on a historical study of market data like price, volume and market breadth. The most widely-used tools for selecting the entry timings are moving average crossover (i.e., price going above a rising moving average or short-term moving average going above long-term moving average), price going above a falling trend line, prices bouncing back from a support, patterns like double bottom (i.e., prices coming to a specific level twice with a reasonable time gap in between), inverted head and shoulders (the pattern looks like a man standing on his head), rounding bottom (like a saucer). The opposite action will result in timing the exit.
