Mean reversion

Three consecutive days of decline in the stock market may have rattled investors, but this is par for the course. It’s just that the strong run by Indian equity in 2017 with the benchmark Sensex gaining 28 per cent, followed by a stellar pre-budget rally in January 2018, appears to have lulled investors into a sense of complacency. Declines are necessary to take stock prices closer to their underlying worth and are healthy, from a long-term perspective, to create the base for the next up-cycle.

The decline this time has been led by the US equity market that was in a similar irrational uptrend. Both the Indian as well as the US market have not witnessed a meaningful corrections exceeding 5 per cent in 2017. Valuation in both markets rose to unsustainable levels. The Dow Jones Industrial Average currently trades at price-earning multiples of 19, way above its 5-year average multiple of 16 and the Nasdaq composite currently sports valuation of 40x. Similar lofty valuation of Indian benchmark indices, especially the mid- and small-cap indices, have made a correction imminent. In their exuberance, markets had shrugged off looming threats such as the consequences of central bank tightening. Prices of most asset classes, including equity, have been supported by the liquidity infused by global central banks, after the 2008 crisis. But with growth stabilising and inflation edging higher, these central banks have been moving towards monetary policy normalisation. The Federal Reserve has moved away from the era of providing cheap money to pushing through three policy rate hikes in 2017. With three more rate hikes expected in 2018, the cost of borrowing in the US is expected to increase further. The Fed’s intention to shrink its balance sheet by gradually reducing re-investments of securities issued for infusing liquidity will, in fact, reduce surplus in the market. With the ECB and the Bank of Japan intending to cut back on asset purchases, the liquidity prop available to global markets is expected to be gradually removed. Another consequence of central bank action has been to push up bond yields, making money move from equity to the more attractive bonds.

If the correction extends for some more time, investors will no doubt be anxious. Market regulator SEBI should increase its investor awareness programmes to keep investors from panicking and exiting equities altogether. With a deluge of money being ploughed into mutual funds over the past year, many new investors have begun investing in equity through the MF route. These investors should be advised to take the fall in their stride. The Indian market has a robust risk-management system that has helped it weather previous falls, in 2000 and 2008, better than other global markets. SEBI should ensure that risk-management rules are adhered to at the exchange and the member level, to protect small investors.

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