“Once a secular market leader puts in a major top, there is a 50% chance that it will decline by 80% and a 80% chance that it will decline by 50%” – Mark Minervini

The above statement is not some random assumption but is a fact as per Mark. Every active trader or a long term positional investor should be aware of this insidious probability of a stock that has been a market leader, which can go down up to 50-80% down once it has made a major top. 

The argument that after the fall,  it can go up again and it will make new highs in the coming future may be true. But the number one rule of an active trader is to preserve his capital that he has made in the bull run and not to give too much in the bear market. A positional trader can beat the index or a passive investor only if he can preserve the gains he makes in the bull market. His drawdowns should be the least to make the maximum profits in the bull market. One should never make it as a buy and hold affair. For a passive investor the things are different.

The above statement would have been published some 10-15 years back, but still it has a 100% relevance and it will have the same relevance in the years to come. In this article we will see how this rule has played out in the Indian market in the recent fall of Nifty after making a major top in Oct 2021.

Why does this happen?

Imagine you had invested a huge amount in a particular stock/ sector. Your timing was right and you had made huge money on it. But, the profit becomes realized only when you book it right? Now, everything was going fine until one fine day when a global bad news broke out. It may also be a local bad news related to that particular sector. One after the other the bad news keeps coming.

(In recent times if you remember it was Russia-Ukraine war, rising inflation, layoffs in bigger companies, FED rate hikes etc.,)

As a common investor what will you do? You will first book the positions of your most profitable trades right? Institutions are no different. They sell heavily on their most profitable positions to protect profits. Only difference between retailers and the institutions is that they distribute and sell first while the retailers come to know it only at a later stage. Also, Sector rotation is an inevitable nature of the stock market. Leader of one cycle will be the laggard of the next bull run. Rare exceptions may be there. But this is what usually happens.

That is why you should be able to identify the Sector rotation and to focus on sector leaders.

How is this Important to us?

So, it is apparent that a sector leader cannot be a leader for all the time. It has to go through the normal up and down movement. 

Just see the example of Mindtree below:

Mindtree belongs to the IT sector and from March 2020- Oct 2021 it made a huge profit of 638% approximately.

However, when it made a major top in Oct 2021, it started to slide down and had a maximum drawdown of about 47% from its top. Near 50% drop from the top. This is what Mark is saying in his teachings.

Now, if you are still not convinced what a 50% drawdown can do to you if you already had made a profit of 638%, then you had not understood the real significance of drawdowns.

Let us assume that you invested 1 Lakh INR in march 2020 after the Covid fall. (Nobody can invest with that precision. Let it be a hypothetical situation.) 

Then your account can made any of the following:

You can see from the above table that Trader 3 even though made a profit of 290% he had given back more than double of the maximum profit. Since no one can predict the top and bottom, let us assume that trader 2 has made a fantastic and realistic profit as he had a plan to exit by simply following the HH and HL framework in a higher time frame. He exited the stock once it broke a major support line and went into a lower high lower low structure. Stop loss based on a higher time frame is more reliable.

See the self explained chart below for further clarity:

I hope that it would be clear why having a proper exit strategy is a must to become profitable in the long run and not give back too much to the market. So, whenever you are having a super successful stock in your portfolio, always remember that it may at any time make a major top and fall anywhere between 50-80% from the top.

Back-testing the falls of leaders:

I was just going through the sectors that made a huge profit in the bull run from Mach 2020 – Oct 2021 and found that, it was Metal sector that rocked with CNX Metal index giving 362% profit and falling upto -35% form the top and second was IT sector with CNX IT index giving 247% approximately and then falling 34% from the top.

(This article is written in November 2022 and I don’t know whether the bottom has been made in these sectors. Metal is recovering fast but IT is consolidating a lot. Only time will tell what will happen)

So, let us see how the star performers in these sectors fell down heavily after they made a major top around October- Nov 2021. 

First will see the metal sector:

See the image below:

The image shows the gains made from March 2020 – Oct 2021 on the left side and on the right side shows the drawdowns from Oct 2021. 

Stocks studied in order are Hindalco, SAIL, Vedanta, Tata Steel, JSW Steel, National Alum:  

You can see that, all these super performing stocks, fell around 46% – 57% from the top. 

Now see the IT sector Stocks:

See the image below:

The image shows the gains made from March 2020 – Oct 2021 on the left side and on the right side shows the drawdowns from Oct 2021. 

Stocks studied in order are : Coforge, Mindtree, LTI, LTTS, Mphasis, Wipro, Infosys, HCL.

Again, the star performers fell around 48- 51%. Interesting thing to note is when the returns were lower the falls were also lower. There seems to be a direct correlation between the maximum returns made and the maximum drawdown. Lower the return, lower the drawdown and vice versa.

See, Infosys for example. It has given a maximum return of 283% but its fall is just -32%. One reason could be the high fundamental value of the stock. So, whenever it came down some value investors would have bought it. Also, since the returns are of low volatility in nature, the stocks of these kinds are usually held by very high institutions like mutual fund houses. They are not going to sell a stock just because it has fallen 32%. They are not momentum players.

So, what should we do?

Accept the reality:

We should understand that sector rotation and leadership changes are inevitable. Be nimble when the market tries to reverse the trend. Failure to understand this simple concept by many of us makes the bull market the toughest.  People make good money in the bull market only to give back all to the market at the end. Control your greed when you are sitting on huge profits. 

Have a Proper exit strategy:

The difficult part of trading is not the entry. It is the exit, Have a proper exit strategy. It can be anything based on moving averages, pivot points, Relative strength line crossing zero line, simple higher high and high low break, break of a major support line or anything you like. See what fits you and master it.

Have a tighter Stop Loss:

When you are trading in a mature bull market you should be very careful in stop losses. Anytime there may be a major downfall coming. So, keep the stop losses tighter, particularly in those stocks which are trading at an “All Time High”.

Remember that in my previous article “Stock selection using relative strength”, I had expressed my preference to trade the stocks at All Time High, with a little space for stop loss. That is because, we are turning around from a major fall and hence the risk is relatively low. 

However, in a mature bull market the market would have already been highly valued and any bad news can start the profit booking, panic selling and down move. Please, understand the difference between them. Also, position size your trades in an efficient way and always stick to it.

Avoid the snowballing effect:

All major fall starts with a smaller down move only. Never average down and never allow the losses to snowball. Smaller losses can become a very huge loss within days. Be prudent. Always track your trading by making a good trading journal. Track your average loss. You average loss should be half the average gains. If your average gain is 20% then your average loss should be 10% or less.

Also, you can consider reading my article on “How to select stocks by using Mark Minervini’s Trend Template” here.

Note for readers: 

Hope, I have shared my thoughts in an easy way to understand. I would like to make sure that I am not a registered analyst. The stock names mentioned here are just for study purpose and not recommendation. Kindly do your research before investing in any of the instruments.

I love writing about the stock market and hopefully will continue to do so in future. Your feedback on my writings and suggestions will be appreciated ([email protected]). It will give me a boost to write continuously. Do it if possible. 

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