There can be a variety of triggers to sell a stock. There are fundamental indicators and there are technical triggers. There are also news-based triggers that can induce you to sell a stock or the market overall. While most traders and investors tend to understand buy signals quite well, it is essential to understand stock market buy and sell signals. The best technical indicators for stock trading like momentum shifts, breakouts, resistances etc can give a good idea about a weakening market structure. Ideally, you should first consider the fundamental factors that should induce you to sell the stock and then ratify it with technical stock trade signals. Here are 6 key signals that it is time to sell the stock.
1. Rising bond yields and tightening liquidity
This is the first trigger that equity investors need to be wary of. There are two separate aspects to this trigger. The first trigger is rising bond yields which is normally an outcome of rising inflation. We have seen that trend in India in the last few months. Higher bond yields are an indication of rising cost of funds and that can have negative implications for companies. But what is equally relevant is the tightening liquidity position in the financial market. When liquidity tightens, yields on the short term instruments also start to go up. These include the CPs, CDs, call money etc. When the short term bond yields rise faster than the long term bond yields due to liquidity tightening, we have a situation where the yield curve takes on an inverted shape. This indicates that the pessimism over the longer term is very weak and could be a sign of a slowdown in growth. That is a clear bearish signal.
2. Negative net working capital
This is again an indication of an impending liquidity crisis at a company. Negative working capital is when the current liabilities are more than the current assets. If the current assets cannot meet the current liabilities then the company has to rely on long term assets to meet the current liabilities. That is a clear case for a maturity mismatch between assets and liabilities. Apart from just looking at the net working capital, the investor must also look at the quick ratio. This considers current assets excluding inventories. The advantage is that you get a clearer picture of liquidity when you exclude illiquid inventories of raw materials and finished goods. This is normally a key trigger to exit a stock.
3. Borrowing costs and profit margins
We have seen this so often. First, the borrowing cost goes up and that shows up in the interest coverage ratio. This can be clearly seen from the trend of the interest coverage ratio. To be more realistic, you can look at the overall debt service coverage ratio rather than just the interest coverage. If consistently falling interest coverage is accompanied by falling NPMs, then it is clearly a signal of deteriorating financial health. We have seen this deterioration in a number of infrastructure companies and is a classic early warning signal.
4. Credit downgrades and bankruptcies
This can be specific to certain industries and capture the industry trend quite precisely. Do we see consistent rating downgrades on the debt paper of a specific industry? This is an example of strained financials and limited capacity to service the debt. Also, if you are seeing more companies in the particular sector finding it difficult to service the debt and defaulting on payments, then it is a signal to get out of that sector altogether. Such deterioration may also be company-specific, but it is a clear signal to sell out.
5. Sustained index declines supported by volumes
If you look at the market peaks of 2000, 2008 and 2010; they were all followed by prolonged periods of market correction. Normally, a correction of 8-10% can be seen as a normal halt in the up-trend. That is quite common and it happens often. But a correction of more than 15% supported by higher volumes and price damage in front line stocks is a clear indication that all is not well with the markets. When you see such sustained selling, especially by institutions, it is time to sell out of your portfolio.
6. High P/E ratios and low dividend yields
P/E Ratios are quite a discrete variable and cannot be judged in isolation. For example, an oil marketing company is available at single-digit P/E ratio but a capital goods company may be available at a P/E of 25 while an FMCG company may be quoting at a P/E of 50. How do you decide on overpricing? The best way is to use peer group benchmarks. If the company valuations are out of line with peer group valuations and if financials are also deteriorating; then it means that the margin of safety is negative. Such stocks are best sold out of.