Is the worst over for the Stock Markets?

One of the most intriguing topics in the current times is the seemingly endless down-slide of the stock markets not only in India, but across the major world exchanges like Dow-Jones, Nasdaq, Nikkei, Hang-seng, etc. While various complex explanations and scenarios are being discussed across various business channels like CNBC, they try to justify the fall in the indices and predict when the recovery would be possible in the stock markets and the overall economy as well. The common Investor meanwhile is facing a dilemma at every step whether to invest in equities or not.
The Mutual Funds say this is the best time to invest (A Mutual Fund is basically a window to invest in the stock markets. The only difference is that our money is handled my Fund Managers in the Mutual Funds. However, the money ultimately finds its way in the Stock Markets and hence its returns are also highly correlated to the Sensex and Nifty). They try to reason that when the Sensex has already fallen below 14-15k levels, you would be entering at a very low NAV (Net Asset Value – an indicator of the Fund-performance). So that when the Sensex recovers to its previous highs of 21000 in the future, your gains will be much higher. However, they used to say the same thing when the index was at 21k! At that time the economic progress of our country was so remarkable (above 9% GDP growth), that the Fund NAV would only sky-rocket with the Sensex.
My advice to everyone however is to stay away from Mutual Funds and Stock Markets for at least until such time as a clear up-trend emerges. Alternatively, safer investments in FDs, NSCs, PPFs or other Fixed-income instruments could be considered. While the present valuations of equities seem to be mouth-watering, in a bear-market the valuations always keep getting more and more mouth-watering. If you watch CNBC-TV18, you must be aware of what a bear-market is. Those who have invested in stock markets during the years 2001 to 2003 must have also experienced the same. Many analysts disagree on the exact technical conditions defining a bear market. However, a very simple and generic definition of a bear market is:
“Bear market is a condition in which there is a secular or sustained down-trend in the price of a stock or an index, where the price keeps making lower highs and lower lows.” Presently we are in a secular bear market as far as the Sensex and Nifty are concerned. This is clearly evident from the following weekly chart which shows the lower highs and lower lows formation of Sensex:

The red arrow points towards the declining trend. As is evident from the chart, the bear market began when the sensex made a high of 21206 in Jan-2008 at point A. Then it declined to 14677 (point K) in March 2008. The new high in April 2008 to 17735 (point B) made some people think that the bull market has once again resumed. However, our worst fears of a bear market was confirmed when the Sensex surpassed its March lows and declined further to 12514 (point L) in August. The blue line touching the price-line above is called the trend line which is downward facing. If Sensex could break this trend line towards the upside, it could be the early signs of the end of this bear market. Till then we can’t say anything. Theoretically this lower-low formation could go up to any figure. Could be 10,000 or 8,000. Only time will tell. The last green colored bar represents today’s close (17-sep-2008) of Sensex i.e. 13262. Chances are that one of the next few bars will surpass the lows of point L i.e. 12514 and make new lows towards the direction of the red arrow.
A bear market is basically a natural reaction to the price. Since last 5 years, from 2003 to early 2008, we were in a secular Bull market (exactly opposite of bear market, where there is a secular up-trend in prices). During those 5 years, the Sensex rose from only 3437 in Jan-2003 to 21206 in Jan-2008. That’s a sustained increase of about 492%. So now, since Jan-2008, the retracement or reaction process has started. It is both price-wise (index already fallen below 12512 levels and still falling) and time-wise (we are in the eighth month of the bear market).
This is the reason that indices are falling while the fundamentals are intact. Many people are wondering why the market is sliding in spite of our Indian company’s fundamentals (like Net-profits, Sales growth, etc.) seem to be okay. The reason is that stock market gains don’t come in a straight line fashion, but in spurts of ups and downs. Although our fundaments are quite strong, the 21k spurt was beyond justification and a reaction was due. These reactions or bear-markets are like seasonal changes in the stock markets and like summer comes after winter, the pattern keeps on repeating. The only difference, however, is that the pattern is not as regular in time as the seasons because a number of variables are involved. Stock price is not just based on the valuations of the company, but is the sum total of several factors like Global economic conditions, Company’s performance vis-à-vis its peers, the future prospects of its Sector as a whole, its dependency on economic variables like Interest Rates, Govt. regulations, etc.
A Bear market is also the symbol of pain and suffering. Especially for those who have started investing in the later stages of the bull market like in Jan-2008, a bear market comes as an awful surprise. So, is the worst over for the markets? How much of this pain is still left? When will this bear-market end and a new bull-market begin? To be frank, no one knows. As no one did during the end of the last bear market which lasted since 2001 to 2003. While it is true that no one can predict exact market tops and bottoms, presently the act of investing anything in stock markets clearly undergoes the risk of the stocks and indices declining further. This is evident from the following facts:
1. A trend is like a running train and no one could say where its final destination is until it stops. For e.g. who could have guessed that during the bull market the trend would stop at 21514. It could have reacted from say its prior levels like 17k, 18k or 19k also. Similarly, people keep guessing that the bottom could be 14k, 12k, 10k, 8k, etc. but only the trend reversal to a new bull market will prove where the end will be.
2. We are just into the 8th month of the bear-market, whereas on an average bear markets are known to last anywhere between 2 to 6 years. (The risk of seeing the NAV declining several percent for such long time is much worse, than the loss of few percent points of NAV due to investing a bit late after the next up-trend or bull-market is confirmed)
3. The global economic condition seems quite grim and chances of a sustained bull-market emerging anytime soon are quite slim. Recent negative events like the bankruptcy of Investment bankers Lehman brothers and the sale of Merrill-Lynch to BOA only worsens the sentiment and is immediately priced into the indices which lose several points on such news
4. Markets across the world are reacting to bad news while ignoring the good news. There is no euphoria or price rise seen due to such positive decline in Crude-oil prices which declined from above 140$/barrel level to the lows of 92$/barrel. These are classic traits of a continuing bear market
5. We are tempted to invest in the mutual funds due to income-tax benefits which we get under section 80C. However, what is the point of saving a few bucks in taxes if our investment is not safe? Tax could also be saved by investing in Fixed Income Instruments like NSCs, PPFs, etc.
Strategies to apply during a bear market: As by definition, prices tend to head south during a bear market, it is obvious that simple “buy-and-hold a stock” strategy is not going to work in a bear market. It used to work in the bull-market. But today, it could be catastrophic if we don’t have a proper plan for investment. This strategy is applied only by professionals who constantly monitor the stocks during short-term and are quick to sell at the slightest prospect of a decline. They are even prepared to book losses in the short-term.
A conservative strategy could be to invest in FDs, PPFs, NSCs, etc. for a period of 6 months to 1 year, and meanwhile wait patiently for the next bull-market to start. Most of the time, such patience really pays off, while eagerly done investments in shares result in our funds being locked in for a long period of time. This is especially true during a bear market like this one.
Another short-term strategy which could be useful in a bear-market without the need for daily monitoring is to buy Put-options. Put-options are tradable instruments in the F&O (Futures and Options) market. It is an instrument whose value is inversely correlated to a Stock/Index (e.g. Nifty Put-option). As the value of Nifty declines, the value of Nifty Put-option increases. However, a complete discussion of F&O is beyond the scope of this article. I’ll have to write another article in future to do this topic justice.
How to see signs of a new bull market: The interface between a bear-market and a bull-market is quite blurry. Like no one could say that from today winter ends and summer starts. There is a slow and gradual shift in the pattern. However, following are the classic signs that a new bull-market is born:
1. Higher-high formation: This is the most basic and classical requirement of a bull market. Instead of the present sequence of lower highs, price should head higher not only in the Sensex, but the individual stocks also. It should break the blue trend-line shown in the above chart substantially (at least by 2% for an index, 3% for a stock) to consider a reversal.
2. Improvement in Front-liners: A bull-market comes to an end when the mid-caps are flying in the air while the front-liners or large-caps refuse to move. Similarly, the opposite happens when a bear market ends. The large caps should show improvement both in terms of profitability and higher share prices. The large-caps should lead the market up. A major portion of the Indices is composed of few heavy weight companies like Reliance Industries Ltd., ONGC, NTPC, SBI, etc. If some of these stocks keep making higher highs, then we could say that the end is near.
3. Improvement in Sentiment: Every bear-market or recession has a new theme. In the last one it was the down fall of Tech sector. Even fundamentally strong companies like Microsoft and Google had declined by more than 50% during that period. Close home, stocks like Infy and Satyam had fared no better. This time the theme is the U.S. Sub-prime crisis and Real-estate decline. Real Estate stocks like DLF and India-Cements have declined terribly. If these stocks start recovering, there could be some relief.
4. Lower Interest Rates: Interest Rates have increased to substantial levels during the last few months by RBI. This was done in order to curb inflation by controlling liquidity. However, lower interest rates are necessary for growth. That is because with lower interest rates, investment demand will increase. If this investment finds its way to increased capacity in industrial sector, it will result in high growth and GDP numbers. Growth is very much required for the Sensex to surpass its old highs and head higher.
5. Improvement in world indices: Due to globalization and privatization, the fates of all word economies are intertwined. That’s why all the indices are correlated. Presently, the bear market is not only going on in our Sensex, but the same thing is there in Dow-jones, Nikkei, hang-seng, etc. For a new bull-market to emerge, at least a few of these indices should make a higher-high formation.

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