The Hindu Business Line : Crash or correction, no reason to panic

NOTHING ever prepares you for a market crash or correction. Uncertainty over market trends can make even the experienced investor feel helpless. For the uninitiated, no amount of reassurance is enough to convince them that equities are not such a bad asset class after all.

If you hold a diversified portfolio and are invested in a set of fundamentally sound stocks, it might be better to avoid the stock pages for a while. You can re-evaluate your portfolio after the earnings season.

Waiting to happen: What happened on September 22, was typical of many a market correction. On just the previous day, the market capitalisation of the NSE and the BSE had touched all-time highs. At the NSE, the volume and value of trade touched record high levels on September 20.

But the euphoria did not take long to evaporate. Reports of scams and investigations proved to be unnerving. People who bought into stocks because it was fashionable and because their neighbour was buying, sold because everybody else did.

While it was typical, it was not an ordinary event. On any given day, the Sensex moves 0.2 per cent, on an average. The 3 per cent downward move was, therefore, abnormal. It has, however, happened before. Of the 4,300 trading sessions since 1987, the Sensex has gained or lost 3 per cent on 350 occasions.

History tells us that the market routinely recovers from these crashes and, as the average daily movement in stock prices is actually significantly smaller, the risks are manageable. For instance, after the market had scaled a new peak in January 2004, stock prices moved sideways until October 2004 before making their recovery. The market may trace a similar path even now. If Corporate India's earnings do not throw up negative surprises, equity prices will recover from any downtrend that may have set in.

Reflecting risk: This correction in stock prices was long awaited. Equity prices were overheated and valuations were running ahead of fundamentals. A decline in earnings growth from 20 per cent to more sober levels after this financial year, which is highly likely, were not factored into the prices. Prices, therefore, had to correct.

The correction appears to be orderly and logical. For instance, on September 22, the larger stocks lost 3.5 per cent, mid-caps 5.5 per cent and small-caps 7.5 per cent. Penny stocks lost more than 7.5 per cent.

This correction could continue. A shakeout in the market succeeds every broad-based market rally. Pretenders fall by the wayside and potential winners gain lost ground. It will be no different this time around.

Most of the penny stocks will not recover. The 420 stocks with market capitalisation of less than Rs 100 crore and trading at prices of less than Rs 5 in September 2004 appreciated by an average of 350 per cent. 150 stocks trading at prices of less than Rs 2 in September 2004 have gained 500 per cent on average.

These stocks could lose up to 90 per cent of the gains made in the past 12 months. It happened in 2000 and it could happen again.

As for other stocks, earnings announcements hold the key. For most large-cap stocks, sustainable earnings growth should be equal to or only just below their PE ratio. For mid-cap and small-cap stocks, earnings growth should be higher than the PE ratio. And for cyclical companies, earnings growth should be significantly higher.

Markets will use this rule of thumb. Most stocks that fail the test may get dumped.

Keep investing: If you look at equities through the prism of what happened in the past few trading sessions, you may lose your appetite for investing.

The stock market will seem like a gambling den and equity investing a lost cause. Behind the madness, however, there is a method. The stock market is as efficient a mechanism for allocation of wealth as any other that exists. The excesses are due to human emotions and perceptions, and are unavoidable.

Equities still remain the most attractive asset class. At the worst of times, they can deliver post-tax returns of 7-8 per cent over a long-term, far better than what can low-risk debt, illiquid real estate and unproductive gold can offer.

If the GDP keeps growing at 12-15 per cent over the next decade, returns will be even more compelling. The case for diligent equity investing in India has never been stronger.

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