New retail investors chasing penny stocks is recipe for disaster

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All bull runs end in a crash. Towards the last phase of the bull run, the market runs ahead of fundamentals, turns excessively risky, retail investors throwing all caution to the winds make reckless investments, but wise investors turn cautious. A feature common to the end game in most bull runs is the froth in low-grade stocks. If this is a danger signal, then, there is danger looming ahead.    

Normally, the price of a stock rises when the market expects the prospects of the company to improve. In the very short run, technical factors like short covering can cause sharp spurts in stock prices. But, when the stock of a bankrupt telecom company is locked in upper circuit continuously for many days and the stock triples in a short period, how do we explain that? Irrational exuberance? Hyper-speculative activity? A cartel at work? Ignorant gullible investors being taken for a ride? It can be any or all of these. Many low-grade stocks are hitting circuits and witnessing hyper-speculative activity. The conclusion is simple. There is bubble in penny stocks and this bubble will burst.

The retail stock rush

A major trend in the market presently is the sharp rise in the number of retail investors. Large numbers of new accounts are being opened, many of them by the millenials in Tier 2 and Tier 3 cities. This is a desirable trend and is to be welcomed. Household savings moving into financial assets is a desirable and healthy trend. It benefits the investors and is good for the economy. Moreover, since most of these new accounts are being opened from Tier 1 and Tier 2 cities, there is decentralization and democratization of stock ownership, which is a healthy desirable trend. However, there is an area of concern. Many of these new retail investors are trading/speculating in the market for short-term gains. Trading is a zero sum game. Long-term systematic investment in good quality stocks/good mutual funds creates wealth; investment in low-grade stocks destroys wealth. This distinction is important. But unaware of this important distinction, many new investors are investing in low-grade stocks – ‘cats and dogs’ in stock market language. Prices of many ‘cats and dogs’ have been pushed up to unjustifiable levels. Non-institutional participation – retail and HNIs – in the cash market is now above 80 percent. Stock prices of many bankrupt companies have been hitting upper circuits for several days continuously. This is a highly disturbing, unhealthy and unsustainable trend. For many retail investors this game will end in grief.

The economy-market disconnect

A major point of discussion in stock markets now is the economy- market disconnect: rising markets in struggling economies. The global economy is in a severe recession; but globally the markets are up by around 40 percent from the March lows. This global rally is driven mainly by three factors: Abundant liquidity created by the central banks, particularly the Fed; historically low interest rates; and expectations of a rebound in growth and earnings in 2021. If the expectations are realized, the rally may sustain. But, it is important to appreciate the fact that valuations are high and since the economic environment is highly challenged, some triggers can cause sharp corrections in the market.

Valuations are high

With Nifty at 10900, valuations are stretched. Presently, there is no clarity on earnings in FY21. A 10 percent cut in earnings is likely. That would put the FY21 PE at around 28, clearly on the higher side. It can be argued that the market has discounted this and is now focused on FY22 earnings, which are likely to be good. But, FY22 is sometime away and a lot can happen in between. Caution is warranted.

Cats and dogs will be slaughtered in a bear ambush

Bluechips, even if expensive, will survive bear onslaughts. They will bounce back. But ‘cats and dogs’ will be slaughtered in a bear ambush. As explained earlier, this bull run is driven mainly by liquidity. Since the macro environment is highly challenging, a sharp correction can happen any time. Therefore, investors have to be vigilant.

The best insurance in this market is to stay with quality. Particularly, quality large-caps in IT, telecom, private sector banking, insurance, FMCG and pharma will be resilient. Quality large-caps will survive bear onslaughts but penny stocks will be thrashed. This has happened many times in the past. History will repeat. Avoid penny stocks. Stay invested in quality. Stay safe!

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Chief Investment Strategist, Geojit A highly respected figure in academic circles in Kerala, Dr Vijayakumar is a keen observer of financial markets.He was  Expert Member, Working Group on NBFCs, Planning Board, Govt. of Kerala and has lectured at the CEU (Central European University), Budapest, Hungary as Visiting Faculty in 2006. Dr Vijaykumar is known for his articles and pre or post-budget TV discussions. He regularly addresses Investor Meets organized by the company and offers investment advice to both new and savvy investors.

2 COMMENTS

  1. This article by Dr. VK Vijayakumar is a priceless and an eye-opener for particularly for New investors like me.
    I will re-shuffle my Portfolio and will include sectors recommended(all in Large Caps) and relax even in turbulent times in the present economic scenario.

  2. Thanks For your Guidance sir, this Article / post will be a blue print ( Route map) to the new investors as well as to all to build (or) restructure their portfolio and create the wealth.
    #Be safe from Penny stocks#

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