How to sense market direction

GIVEN that the market is trending higher, a lot of retailer investors are tempted to enter the fray again. However, due to the bad experience they had in the past, they do not have the courage to enter at the current level because a lot of shares they bought earlier are still selling at very low prices. Unwilling to put in fresh money, the majority of them are still contemplating on whether to join the ride or not at this moment.

If we analyse the market, we will notice that even though there are higher prices with higher trading volumes, there is not much retail participation.

Based on our observation, over the past few months, our market was filled with long-term investors, institutional fund managers as well as experienced traders. Long-term investors and institutional fund managers will do some selective buying and selling to rebalance their portfolio while experienced traders will trade situation stocks based on the latest market tips and “hot stocks” which are highlighted in major newspapers or research reports.

Experienced traders like to trade “hot stocks” as the businesses of these companies normally grow faster than their stock prices. For example, it is much easier to trade glove-making companies as the business is growing at a higher rate and analysts will extrapolate their earnings forecasts to justify their current stock prices.

The table shows four major market stages and the participation of various types of investors. From the table, we will notice that long-term investors and institutional fund managers will buy when the market is trading at depressed price levels and sell during the bubbles (Stages 1 & 4). For Stages 2 and 3, they will buy undervalued stocks and sell overvalued stocks.

Experienced traders will continuously buy and sell stocks during the bull market (Stages 1 & 2). Even though some of them may participate during a bear market (Stages 3 & 4), the volume is relatively quite small.

Lastly, retail investors will only enter the market again when the overall market is selling at very high levels. They tend to buy into bubble (Stage 1) and sell stocks when the stock prices tumble to very low level (Stage 4).

Retail investors will not participate in Stages 2 and 3 because most of their stock holdings are of poor quality. They will have to wait until these stocks start to trade higher than their purchase prices.

Based on our observations, once these poor quality stocks start to trade higher with heavy volumes (normally they are the top 10 highest trading volumes), it will usually be followed by some major market corrections a few weeks later.

Lastly, given the very low retail participation in the stock market, we feel that we are currently either in Stage 2 or 3. Long-term investors and institutional fund managers will buy and sell stocks while experienced traders will only join if the market resumes its uptrend. Otherwise, most traders will not participate in the down market.

Hence, we need to be careful when the retail investors start to enter the market again as it may signal that the market is due for some correction soon.

Ooi Kok Hwa is an investment adviser and managing partner of MRR Consulting.

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