You found a company with an amazing product. Strong demand was fuelling big earnings and sales growth. Mutual fund sponsorship was top-notch, and the stock was in a bullish technical pattern.
But the stock went lower soon after you bought it because you were wrong about the direction of the general market.
Mistakes are plentiful during a market downtrend. Avoid these common ones, and you will be able to keep your hard-earned cash intact.
• Buying before a base completes. During the recent market correction, many stocks pulled down to their 200-DMA and found some support. To some traders, long-term support was a buying opportunity.
Let’s take the example of Marico. While we have no doubt about the Company’s strong position in the coconut hair oil segment (44% value market share), its stock came under selling pressure owing to the weak market condition. After making a high of Rs 387.85 on August 24 (1), it began the downward journey that saw it breaching the key support level of 50-DMA (2). It then found some support around its 200-day line for few sessions (3) but failed to stay above it in the midst of a weakening market. Marico has corrected 21% from its high and is trading 6% below its 200-DMA. This is one good example that highlights the risk of buying stocks at support levels during a market downtrend.
The key to making money in the market, though, is waiting until a base completes before buying. In most cases, stocks that come down to their 200-day lines do so amid signs of institutional selling. Make the stock prove itself more, and look for signs of institutional buying as the stock builds the right side of the base. Then you have a legitimate base.
• Buying every possible breakout. Bullish stock charts tempt investors all the time during down markets. Some growth names will hang in there with compelling charts.
A breakout may work for a while, but it will likely be short-lived. While stocks that hold up the best during down markets can go on to be the next leaders, they still should not be bought during a downtrend.
Biocon broke out of a cup-with-handle base on September 18 (1), the day when Nifty recorded its fifth distribution day and the market condition was Under Pressure. We decided to wait for the market condition to improve before adding it to our model portfolio. While Biocon got the better of the market in the next few sessions (2), it could not fight the overall trend in the end. It has corrected 14% from its all-time high and is currently struggling near its 50- and 200-DMA (3).
• Staying married to a stock or even averaging down. A stock trades at 100 a share. Your cost basis is 100. The stock heads lower, and you buy an equal amount of shares at 80, lowering your cost basis to 90. The problem is that you’re averaging down in a former leader that’s under tremendous institutional selling pressure.
This is how serious damage is done to a portfolio. It rarely makes sense to buy a stock that has the potential to spiral lower before finally hitting a bottom.
In case of VIP Industries, investors who had booked profit when the stock breached its 50-DMA (1) would be in a much better position compared to others who kept averaging down as it approached its 200-DMA (2). VIP Industries has been a star performer since the beginning of 2017 and has multiplied almost five times in a period of 18 months. Now that it has undercut its 200-DMA for the first time in 22 months, it could be in for a breather. And if you kept averaging down in VIP Industries you might have to wait for a good period before it takes off again. VIP Industries was part of our portfolio and we had removed it on September 11, booking a profit of 16%.
• Buying low P/E stocks. Price-to-earnings ratio is a common valuation tool on Dalal Street. Expensive stocks can become cheap, but cheap stocks become cheaper in a down market. Trying to catch a stock “on sale” is fraught with risk.
In many cases, stocks with low P/E ratios are suffering from weak fundamentals, where shrinking market share results in lower earnings growth. That’s not something you want to see in a stock. Remember, some of the best merchandise in the stock market often sells at a pricey valuation due to strong fundamentals and bullish growth prospects.
• Stop paying attention. It is easy to lose interest when stocks are selling off, but market downtrends let high-quality names take a breather and eventually build new bases.
When a new uptrend is confirmed, breakouts deliver the biggest gains. During a market pullback, try hard to make a list of stocks that held up the best. A few will show limited signs of distribution (heavy-volume selling) on the way down and accumulation (high-volume buying) on the way up. Focus on the most resilient names with the least amount of technical damage. They will generally be your best prospects.
Related: Should You Buy Stocks on Dips?
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