How to Invest in a High Liquidity, High Valuation Market 

Two famous fund managers have started feeling somewhat uncomfortable about the stock market.

One of them is an American while the other one is an Indian.

James Chanos, the American fund manager is of course, feeling uncomfortable about the US stock market.

He believes that it has become highly speculative in nature. In fact, he has not seen a more speculative market in his 45-year long career except for the year 2021.

As per him, the current US market is as speculative if not more than the market of 2021.

Now, Chanos is a highly successful investor in the US and therefore, when he speaks, it helps to listen.

You see, when it comes to investing, there is investment and then there is speculation.

Investment is an operation which upon thorough analysis promises safety of principal and an adequate return. Operations that do not meet these requirements are speculative in nature.

Now, what Chanos is saying is that what is happening in the US stock market is very little investment and too much speculation. In other words, people have become so careless that there is no safety of principal anymore.

Investors are taking huge risks and are risking their entire capital.

To be honest, speculation has always been there in the stock market. However, as a component of the total investment activity, its percentage has varied over the years. In some years, the speculative activity is on the lower side while it is higher in other years.

Right now, though, the speculative activity is the highest it has ever been in the US stock market as per Chanos.

Let me tell you that Chanos loves to track bad quality companies and also the ones that are trading at very high valuations. He tracks them not because he wants to invest in them. It is the opposite. He tracks them because he wants to profit from their share price collapse.

So, he likes a bubble to develop in overhyped companies with very bad fundamentals and then bets on their stock price collapse. And when the collapse starts, which it does more often than not, Chanos earns his money and walks away with a big, fat profit.

Put differently, he has a keen eye for speculation and therefore, when he is saying that speculation has gone up a lot in the US stock market, it will be foolish to ignore him.

Back home in India, it is Sankaran Naren of ICICI Prudential who is getting a little uncomfortable with the market.

On being asked how one should invest in this kind of market where there is so much liquidity and which does not seem to go away any time soon, here's what Naren replied.

• Very tough task because see, over the years and thanks to too much experience I would call it, we are trained to be fundamentalists. We are not trained to think so much in terms of liquidity. We are trained to think in terms of fundamentals and valuations.
  
  And we have seen this phase. In my investing career, I have seen one such phase, particularly in this 94-95 phase, where you had too much liquidity in the market, and we have again this phase.
  
  So, what happens is, when you have too much liquidity and valuations are high and there does not seem to be any threat to the liquidity, there is no margin of safety.

So, James Chanos has used the term 'highly speculative' for the US stock market while S Naren has described the Indian market as a market where there is 'no margin of safety'.

If you think about it, the terms 'speculation' and 'margin of safety' have a deep relationship with each other.

When the margin of safety is low, the risk is on the higher side and when the margin of safety is high, the risk is on the lower side.

Let me help you understand with an example.

Say a stock has an intrinsic value of Rs 100 and the stock is available at a price of Rs 50. The margin of safety here is huge.

If a stock has an intrinsic value of Rs 100, there is very little chance that it will fall below Rs 50, its current share price.

On the other hand, even if it goes up to Rs 75 over the next 1-2 years, you will still end up with good returns on the share price of Rs 50.

On the other hand, if the price of the share is not Rs 50 but Rs 90 right now, then the margin of safety is low. So, if the stock now falls to Rs 75, you won't end up with a profit but a loss in the region of 20%.

So, the learning from this example is this.

When a stock with an intrinsic value of Rs 100, trades at Rs 50 or lower, the margin of safety is high and the speculative element is low. But if the same stock trades at Rs 90, then the margin of safety is low, and the speculative element is high.

Therefore, a high margin of safety leads to low level of speculation and a low margin of safety leads to a high level of speculation.

Hence, both Chanos and S Naren are effectively saying the same thing about the US and the Indian stock market respectively.

They feel that the speculative element has gone up in both these markets and the margin of safety has gone down drastically.

Now, this brings us to the next important point.

If the margin of safety is low and if both the markets have become highly speculative in nature, how should one go about investing, especially when it is quite clear that the liquidity is going to remain strong and there is a strong chance markets will keep going higher.

Let me repeat that. How to invest in market where valuations are high, speculation is high, and margin of safety is low, but liquidity is stronger than ever and where markets may continue to go higher?

Well, the solution is quite simple to be honest. You need to buy stock market insurance. Yes, you heard that right.

You see, you buy normal insurance policies to protect your family, your assets and yourself from financial risk/losses.

Likewise, you also need to buy a stock market insurance to protect yourself against a stock market crash.

And this insurance is nothing but the amount of money you want to set aside as cash or in the form of bonds or fixed deposits. And the proportion of bonds or fixed deposits will depend on how speculative you think the market has become.

If the market is highly speculative and there is no margin of safety, then you can be as much as 40%-50% in bonds or fixed deposits or even higher.

If you feel that there is low risk to the market and the market will keep going up, then maybe you can be 75% in stocks and only 25% in bonds. However, keep the bond amount to be meaningful at all times.

You should not allow it to go below 25%, especially right now when the speculation in the market is on the higher side. Having at least 25% in bonds or fixed deposits gives you enough money to invest after a market correction when the margin of safety will once again be on the higher side.

So, if you have lumpsum money to invest in stocks right now, keeping at least 25% aside in cash or fixed deposits, would be a good idea.

It is an insurance that will not only minimise your losses in a market crash but will also give you ammunition to buy stocks where the margin of safety has gone up to attractive levels.

In conclusion, the formula is quite simple. When the speculative activity is down and margin of safety is big across stocks, you can have little to no insurance. However, if the speculative activity is up and margin of safety is very low or is non-existent, then do have substantial insurance in the form of cash or fixed deposits.

And yes, please don't make the mistake of assuming that you don't need any insurance because you are buying the best businesses. Well, even the best businesses suffer significant share price declines during a market crash. No businesses are spared. Mega caps, large caps, mid caps, small caps, micro caps - all stocks fall in a market crash. Hence, insurance is a must especially during current times when speculative activity is at its peak.

I will see you again in the next session. Goodbye and happy investing.