Animal spirits

‘The Sensex is at a high. It’s a new bull market.’ ‘No, with so much gloom, this is surely a bear market.’ Arguments such as these have become commonplace since the Sensex began flirting with its all-time high recently.

However, a bull or bear phase cannot be identified merely from the standpoint of the Sensex. The behaviour of individuals who invest in the markets can offer invaluable clues about how far a rally or decline can go.

One of the earliest studies in this area was done by Charles Dow. He divided bull and bear markets into three phases and went on to describe the behavioural attributes of each phase in detail. Frost and Prechter, in their iconic book, The Elliott Wave Principle , refined these guidelines further.

While not infallible, these theories can help alert an investor about an impending crash or a lucrative buying opportunity in the market.

We decided to go back to them to see where the market stands today.

Three Faces of the bull

Pervasive gloom

Investors continue to reel under the devastating effects of the previous bear market and use every rally to sell. There’s plenty of short-selling too, amid dismal news headlines. This is when smart investors begin accumulating stocks, mostly bluechips, at basement prices. The first quarter of 2009 is an ideal example of the accumulation phase when there was widespread talk of impending recession.

Despite the Sensex trading at historic lows, retail investors stayed away. Foreign institutional investors were the first to begin shopping in this quarter.

The party begins

The second-phase of the bull market is the most powerful with almost all stocks making strong gains. This is the phase where the most gains are to be made and Prechter aptly describes this phase as ‘wonders to behold’. Both the economy and company fundamentals begin to look up.

The Indian stock market rally seen between 2004 and 2007 is a typical example of the second phase in the bull market when the Sensex rallied from 4,000 to 14,000 points.

It’s past midnight

In the last phase of the bull market, optimism runs high. This is the time when small-cap stocks with poor fundamentals — the cats and dogs as they are called — join the party.

The last quarter of 2007 is a case in point. Even as the Sensex gained 17 per cent in that quarter, the BSE Smallcap Index shot up 41 per cent in three months.

The strong price moves attract investors of all kinds, including the shoe-shine boys of Wall Street legends and housewives from Mulund.

The primary market booms as promoters rush to issue shares at hefty valuations while the going is good. Think back to the sensational Reliance Power IPO in January 2008 in which 50 lakh investors participated.

Three faces of the bear

Optimism continues

The downtrend or bear market that usually follows a bull run can also be divided into three phases. In the first phase of a bear market, optimism rules high. Whenever the market dips, investors believe that it is just a small correction and see an opportunity to buy. In the market crash of the last week of January 2008, investors scrambled for bank loans to buy stocks.

It is the blue-chips that start correcting first even as the buying orgy in mid- and small- caps continues. Investors kept rushing to buy IT stocks between April and May 2000 despite the index having topped out in February 2000. Institutional investors, obviously, are already in exit mode in this stage, offloading their holdings to novice investors.

No place to hide

In the second phase of a bear market, the number of declining stocks increases. It comes to a point when there is no place to hide. Theory has it that while 72 per cent of the stocks participate in a bull market, 90 per cent of stocks nosedive in a bear market. Optimism gives way to nervousness.

Fear, panic

In the third phase of a bear market, bluechips are done with their declines. It is the small-cap and mid-cap stocks that continue to dredge new lows amidst all-pervasive pessimism. Very often, all this ends with a panic low in the market caused by events such as the World Trade Centre bombing in September 2011 or the Lehman Brothers’ collapse and global credit market squeeze of 2008.

While a bull run that goes on without a stop or a bear phase that simply takes prices lower and lower would be easy enough to identify, what makes market cycles complicated is the intermittent corrections. The three phases in both an up and down-cycles can be interspersed by a counter-trend that can be sharp and swift or sideways and long-drawn. One such phase was witnessed between September 1994 and November 1998. And markets do tend to spend inordinately long periods of time in these sideways phases; which can be very perplexing.

Spot the animal

So, armed with all that theory, why not get down to the brass tacks and analyse which phase the Indian market is in currently?

It is obvious that the last six months of 2007 had all the features of the third-stage of a bull market and the three bear market phases can be identified between January 2008 and October 2008. The scepticism about the rally in the first half of 2009 had all the hallmarks of the first stage of a new bull-phase.

What has followed from November 2010 is more like a consolidation phase within a secular bull market.The overwhelming scepticism when the Sensex notched fresh life-time peak this November, under-performance of mid and small-caps, a moribund primary market, poor retail participation and gloom in economy do not signal a bull-market top. Therefore, the current phase appears to be more like the initial stages of a secular bull-trend.

The sideways move that began in November 2010 is now 36 months old. But a similar sideways move in 1990s absorbed 50 months. In other words, the sideways move can continue for a year or more. But when prices do break out, that will be the most profitable part of the bull market, the party phase.

>lokeshwarri.sk@thehindu.co.in

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