Markets on Fire: How to Profit Without Getting Burned

One is American fund manager James Chanos, who is nervous about the US stock market, and the other is ICICI Prudential’s Sankaran Naren, who is nervous about the Indian domestic market.

Chanos believes the market has become highly speculative. In fact, he has never seen a more speculative market in his 45-year career, except for 2021.

He feels the current U.S. market is just as speculative, if not more so, than the market will be in 2021.

Chanos is a very successful investor in the United States, so it pays to listen when he speaks.

When it comes to investment, there is investment and speculation.

An investment is a transaction that, based on thorough analysis, promises safety of capital and satisfactory returns. Transactions that do not meet these requirements are speculative in nature.

Now, what Chanos is saying is that what’s happening in the U.S. stock market is that there’s too little investment and too much speculation — in other words, people have become so careless that there’s no longer any safety of capital.

Investors are taking a big risk and putting their entire capital at risk.

Now, let’s be honest here: speculation has always existed in the stock market.

However, its share of total investment activity varies from year to year, with speculative activity being lower in some years and higher in others.

But Chanos said speculative activity in the U.S. stock market is currently at an all-time high.

Chanos loves to follow poor quality companies and companies that are trading at sky-high valuations. He doesn’t follow them because he wants to invest in them. Quite the opposite: he follows them because he wants to profit from their stock price crashes.

So he likes to create bubbles in overvalued companies with very poor fundamentals, then bets that the company’s stock will crash, and when the crash starts (and it usually does), Chanos has made his money and is walking away with huge profits.

In other words, he has a keen eye for speculation, so it would be foolish to ignore him when he tells us that speculation is increasing significantly in the U.S. stock market.

Inside India, ICICI Prudential’s Sankaran Naren is a bit uncomfortable with the markets.

When asked how one should invest in such a market which is highly liquid and not likely to disappear anytime soon, Naren said:

It’s a very difficult task, because over the years and because of what we call a wealth of experience, we’ve been trained to be fundamentalists. We’re not trained to think in terms of liquidity. We’re trained to think in terms of fundamentals and valuation.

And we’ve been through this phase. We’ve been through one phase in my investing career, particularly this ’94-’95 phase, where there was too much liquidity in the market. And we’re going through this again.

So, if there is too much liquidity, valuations are high, and there doesn’t appear to be any threat to liquidity, then there is no margin of safety.

Chanos used the term “highly speculative” to describe the US stock market, while Naren described the Indian market as one with “no margin of safety.”

If you think about it, the words “speculation” and “margin of safety” are closely related.

If the margin of safety is low, the risk is high. If the margin of safety is high, the risk is low.

Let me explain with an example. If the intrinsic value of a stock is ₹In stock at 100 ₹50. The margin of safety here is very large.

The intrinsic value of the stock ₹It’s unlikely to fall below 100 ₹The current stock price is 50.

On the other hand, even if it ₹If it moves above 75 over the next 1-2 years, the stock will still likely earn good returns. ₹50.

Meanwhile, stock prices ₹50 But ₹If it’s at 90 right now, the margin of safety is low. So if the stock price falls to 90 now, ₹At 75, you will not make any profit, but rather a loss of around 20%.

So, the lessons learned from this example are:

Intrinsic value ₹100, transaction price ₹If it is below 50, the margin of safety is wide and the speculative element is low. However, if the same stock is below 50, ₹At 90, the margin of safety is low and the speculative element is high.

Thus, a high margin of safety leads to low levels of speculation and a low margin of safety leads to high levels of speculation.

So Chanos and S. Naren are essentially saying the same thing about the U.S. and Indian stock markets, respectively.

They feel that speculative elements have increased in both markets and the margin of safety has significantly decreased.

Ok, this brings me to the next important point.

How do you invest when the margin of safety is low and both markets are highly speculative in nature?

This is especially important when it is clear that liquidity remains strong and markets are likely to continue to rise.

So again, how do you invest in a market where valuations are high, speculation is high, margins of safety are low, but liquidity is stronger than it’s ever been and the market is likely to continue to rise?

To be honest, the solution is very simple: you need to buy stock market insurance. Yes, that’s right.

As you know, traditional insurance is taken out to protect your family, assets and yourself from financial risks and losses.

Similarly, you should buy stock market insurance to protect yourself against a stock market crash.

And this insurance is nothing but the amount you want to set aside in the form of cash, bonds or fixed deposits.

This percentage of bonds or term deposits will depend on how speculative you think the market has become.

When markets are highly speculative and there is no margin of safety, the proportion of bonds and term deposits can be as high as 40-50% or even more.

If you feel the market risk is low and the market will continue to rise, you can go for 75% stocks and 25% bonds, but always make sure the amount of bonds makes sense.

You don’t want it to fall below 25% especially at a time like now when there is so much speculation in the market.

Keeping at least 25% invested in bonds or fixed deposits will give you enough money to invest when the margin of safety becomes high again after a market correction.

So, if you have a lump sum of money to invest in stocks right now, it’s a good idea to set aside at least 25% in cash or fixed deposits.

This is insurance that not only minimizes losses during a market crash, but also gives you the ammunition to buy stocks when the margin of safety has risen to an attractive level.

In conclusion, the formula is very simple: when speculative activity is declining and the margin of safety across equities is large, little or no insurance is needed.

However, where speculative activity is high and the margin of safety is very low or non-existent, adequate insurance should be taken out in the form of cash or fixed term deposits.

And don’t make the mistake of thinking that you don’t need insurance because you’re buying the best business.

During a market crash, even the best companies see their stock prices fall dramatically.

No company is immune. Mega-cap, large-cap, mid-cap, small-cap, micro-cap, all stocks will fall in a market crash. Hence, insurance is a must, especially in the current situation where speculative activity is at its peak.

Disclaimer: This article is for informational purposes only. It is not a stock recommendation and should not be treated as such.