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During the first three weeks of July the All Share Price Index (ASPI) has continuously gained increasing by 343 points with one single day been the exception in which the index lost just 20 points.

In other words the index rising sharp by 5.4 percent within a period of less than a month represents nothing short of a mini rally.

Also the turnover levels were buoyant averaging around Rs.  1.9 billion per day. Foreign investors continued to be net buyers to the tune of Rs. 3.6 billion, while total overseas purchases amounted to Rs 7.8 billion and the sales were Rupees 4.2 billion.  Despite  been strong, foreign participation levels in the market has come off from around 40 percent levels to 25 percent which I think is more to do with local trading activity rising strongly.

Best performing frontier market

YTD 2014 the Colombo bourse has gained around 13 percent and has been one of the best performing Frontier markets. This growth in the market was not evenly paced and almost half of the rise in ASPI happened during the last 4 weeks, and now the valuations are been pushed. Presently the entirety of the listed stocks at the Colombo Stock Exchange (CSE) is trading at 15.27 times past 4 quarterly earnings, which is relatively high but far below the multiples of around 25 times reached during the market peak of 2011.

Local investor participation is robust with institutions, High Net-worth Individuals and retailers all jumping on the bandwagon. It seems as the sentiment has changed rather swiftly after the timely entry of the larger local institutions.

Foreign trading waning

However foreign trading activity which sustained the CSE for the past year or so seems to be waning with foreign purchases which were on average above Rs.880 million per day during the first week of July dropping by half during the second and third week of the month, while the selling levels remained unchanged.

Given the spike in the index within a short time span seasoned global investors may want to sit out this mini rally and see where the market settles rather than putting in more money stretching the valuations further. Having said that corporate earnings growth would be the key magnet to rekindle global investor interest, though sharp profit growth amongst the listed companies is unlikely in the second quarter for which the results are yet to be released.

Therefore, the foreign investors who accumulated stock last year could exploit the opportunity of booking profits while a marginal correction at the Colombo bourse is most likely. Further on relative terms the upward prospects of other frontier markets in Sub Saharan Africa, South America and closer to home countries like Bangladesh, Pakistan and Vietnam may divert attention of the global investors at least for the short term till market valuations become attractive again.

Local investors gain confidence

However the local investors who lacked any poise few months back seem to be on a jovial mood with confidence plenty. Interest rates been low and limited alternate investment opportunities are cited as reasons but my concern is at the current valuations if profit growth does not pick up while the index remains strong, foreign investors would sell their stocks to the locals and wait out the correction. Therefore I think local smart money should become smarter and pick the stocks with potential which has not yet benefited from this recent rally rather than chasing after the index heavy weights at stretched valuations. So far in July we saw most of the interest surrounding the blue chip stocks, but its most likely that interest would spread broadly if momentum continues.

And this is where the retail investors need to be extra cautious. Interest rates may be down, alternate investments or trading opportunities may be limited but it is best to invest and trade in the market with some fundamental conviction rather than blind faith on a stock which could provide you with magical returns.    
 
Having been conservative I also have to mention that there is potential pickings and further upside at the CSE. The broad market is trading on mid-teens which is normally considered to be on the high side while there are many stocks still trading at and around 10x trailing earnings. Also these low price earnings multiples coupled with strong dividend yields and a healthy return on equity are stocks with a fundamental backing which could rise in price.

On the same note if one decides to do more trading than investments at the CSE, a better approach during a market upturn is to book profits at high frequency. Such actions would ensure the trader often realizes his gains while indirectly provides more depth to the market and enables accurate price discovery.  However the risk remains, if the index heavy large cap counters which are getting heated does go through a correction it may drag the entire market with it. While the consolation been as long as portfolio additions are made on sound fundamentals the downside is limited. Another time tested strategy which can be followed to minimize losses during a market correction is to be disciplined enough to cut losses without eternally holding on to stocks despite seeing the prices in a downward spiral. Seasoned traders follow various self-imposed rules, as an example selling any stock if the price has fallen 10 percent from cost and thereby limiting the maximum loss in value to 10 percent. The percentage ten was just a hypothetical figure used to explain the scenario and any trader should select the maximum cut loss percentage as per his or her own choosing.

Also some play safe. Investors select stocks with high dividend yields and tries to hold on to their investments despite a decline in stock prices while trying to add more and average down the total cost of acquiring the stock. All these are basic techniques which one can follow to limit any downside risk while realizing the gains when trading in stock markets.