Introducing the MST
We have built this tracker in order to help track the greed/fear index in the market. In simple words, this helps us compare the fair value with the current market value of our index. The tracker has been built out of 20 quality stocks (small, mid and large-cap) the list of which will be shared soon. In the coming days we look forward to incorporate more companies into the tracker which will help improve the efficiency of this tool.
How does this work? Let's take the following case:
Suppose we have 5 companies in the tracker. The market value of the index is at Rs. 10800 whereas our valuation model suggests a fair value of Rs. 8600. This will tell us that the market is currently pricing these stocks at a premium of about 25%.
Let's say that we have found that historically whenever the market value of the index is trading at more than 50% premium, the overall market tends to correct itself sometimes after that. Or if the market is trading at a discount of 20% to fair value, we will be quite confident in determining based out of past relationship that the bottom generally forms around this area.
DATA AS OF JULY 2020 -
The above chart depicts the ratio being calculated by dividing the market value of the stocks by their fair value. Therefore, a ratio of 1.5 tells us that this index is trading at a 50% premium of what our valuation models suggest the fair price should be whereas a ratio of 0.8 tells us that the market is trading at a discount of 20%.
Established historical relationships -
(i) When the ratio nears 1.6 (60% premium), the models suggest 'Extreme' overvaluation and an incoming correction.
(ii) When the ratio nears 1.35 (35% premium), the models suggest to be 'Cautious' and to avoid fresh investments.
(iii) Ratio from 1.1 and below suggests fair/under-valuation where one should start buying into the markets.
This chart is updated every 15 days in order to capture the market value movements in the market. However, the fair value gets updated on -
(i) Every quarter basis when the company results are announced
(ii) When there is an important development that recently happened that is expected to impact the company operations.
(iii) When the company announces anything that will impact its value.
The fair value is calculated based on complete factual information with slight tweaking (to a limit) to the final company value in order to reflect the expected performance of the company in the future. A detailed note on how we go about calculating FV of a company will be shared soon. Highly uncertain events like Covid-19 which are expected to have a material impact on the business operations have to be adjusted manually and are subject to bias and personal views. Currently, we have applied a rough 20% discount of the values due to the Covid-19 impact on each company based on the expectations on how their business operations will be impacted.
How to benefit from the market sentiment tracker? Here's how we are currently using the tracker to make meaningful decisions -
(i) We are currently taking buy/sell decisions based on the fact whether the market is trading within the fair value range or not.
(ii) It helps us ignore our personal bias, ignore emotions and take action based on what the indicator tells us.
(iii) It helps us understand the overall market sentiment and help us in making allocation decisions.
For example, in early 2018 when the model was flashing warnings, we shifted a good portion of our holdings into bonds. Yes, it was difficult to see the stocks further rise throughout 2018 but in the end, they finally started correcting. Now again, we have started buying stocks and selling bonds as of Feb 2020 in a staggered approach.
If you require any assistance/clarification on the working of the market sentiment tracker (MST), please feel free to contact us.