ARE YOU PREPARED FOR A MARKET CORRECTION?

(Source : Cartoonresource/Shutterstock)

With the bull market setting new high’s every week, it might seem preposterous to prepare for a correction. However, it does pay to be forewarned since, ‘to be forewarned is to be forearmed’.

Historical FII ‘flows’ in Q4.

The Indian market is heavily dependent on FII (Foreign Institutional Investor)  ‘flows’. Any downturn in the market, has, more often than not, come on the back of FII selling. Is there a trend in the FII ‘flows’? I did a historical  analysis of  FII  ‘flows’ for the  calendar years from 2009 to 2013, for the period from June to December, and this is what I found (All figures are rounded of and  in Rs. Crores):

 

FII ‘Flows’ 2009-2014

 

YEAR	2009	2010	2011	2012	2013	2014
JUNE	85	7,714	2,663	2,795	11,425	7,332
JULY	1,365	8,541	4,282	5,903	414	6,965
AUGUST	3,767	7,537	11,559	7,747	7,470	2,681
SEPTEMBER	13,331	22,476	3,089	20,808	11,176	5989 *
OCTOBER	0.13	14,388	1,842	8,443	17,556	?????
NOVEMBER	1,708	5,351	6,509	6,292	6,956	?????
DECEMBER	4,241	722	2,387	14,366	13,466	?????

* This is till Friday, 19 th September, 2014

(Source: Moneycontrol)

The month wise Nifty returns in percentage terms are given below:

 

Nifty Month-Wise Returns 2009-2014

 

YEAR	2009	2010	2011	2012	2013	2014
JUNE	5.27	6.89	0.99	9.03	1.63	3.38
JULY	6.81	2.21	2.58	0.94	2.66	1.13
AUGUST	1.05	0.54	9.35	0.34	4.47	4.63
SEPTEMBER	9.91	10.2	1.92	8.56	3.32	1.17 (*)
OCTOBER	7.31	2.05	9.84	1.73	8.98	??????????
NOVEMBER	10.27	4.17	8.10	4.16	0.16	??????????
DECEMBER	1.54	2.91	6.33	0.58	1.39	??????????

 (*) This is till Friday, 19 th September, 2014

(Source: Nseindia.com)

 

From the data given above,  we can easily draw the following conclusions:

• It is apparent that FII inflows do ‘taper’ off in October and November, in each calendar year.The calendar year 2013 was an exception, the reasons for this are well documented. They are not relevant for the current calendar year.

• The FII  juggernaut does seem to start rolling from December onward.

• There is a one to one correspondence between, Nifty returns and FII ‘flows’. However, it is important to note that this is only in the direction of the market, not in the magnitude of the change. In other words, small FII outflows at times lead to big corrections and vice versa.

• Since the FII’s operate with a ‘herd’ mentality, this has a consequential impact on the ETF ‘flows’ in to the India Specific ETF’s listed in the U.S.

• This does not mean that the market will fall off a cliff. It definitely means that index wise gains for the last quarter are likely to be muted. It seems, to me, that the market is likely to be sideways, with a downward bias. This does not mean that it is time to go short.

• What I am effectively warning against is ‘complacency’, which, I think, has set in. The bull side of the street is getting a little crowded. What do you expect, with so many skeptics ‘crossing over’.

• In the Global universe, the last fortnight has seen the longest decline in Emerging Market stocks for over a decade. On Friday, 19th September, 2014 the MSCI Emerging Market Index closed at 1053.92, 4.56 % below it’s 52 week high of 1104.31, set on 04th September, 2014. Have a look at the  image below, which shows the movement of this index for the last three months. Is this just a correction or will it continue?

 

MSCI  EMERGING  MARKET  INDEX

 

 (Courtesy : The Financial Times, London)

 

Volatility and bull markets

 

Is it easy to make money in a bull market? I think not. It just looks easy in hindsight. Why? The volatility generally makes it difficult for people to hold on to their ‘buys’. A stock market devoid of volatility would yield lower returns. Volatility is  common in bull markets. It is a necessary evil. One has to ride it to seek market like returns over time. This has been a placid year so far. The volatility has been abnormally low this year. The chart below shows the India VIX (Volatility Index) for the year 2014.

 

 

The market has been trending upwards from April 2014.  After a  29 % upside in the Nifty, the sentiment is mixed. In other words:

• It has settled to the middle, neither bullish nor bearish.

• In such situations we generally have something different happening. A big up or a big down – extremes.

• In the current situation Bulls have become less bullish. The bears are tiring of the being the boy who cried wolf. In such situations, markets tend to surprise both the camps.

• In other words, the volatility will go up. Volatility does not necessarily mean negatives, positives can be equally volatile. We don’t need to be worried about positive volatility. The negative volatility is, effectively, the cost of doing business for an equity investor. Negative volatility means a correction which is usually defined as 10 %.

Bull Market Corrections – Characteristics

 

All bull markets have to go through corrections. A correction is a sentiment driven, sharp and short move, of around 10 % or more. There is no fixed percentage as such. The characteristics of corrections are:

• Corrections typically start without warning and are impossible to forecast. They last for a few weeks to a few months.

• Corrections in bull markets are generally steep. Corrections are refresher’s, providing a ray of hope to bears, that their predictions are finally coming true, and a reality check for bulls.

• Bull market corrections are driven by sentiment and not by fundamentals. Sentiment swings on a dime. Corrections  caused by sentiments and not by fundamentals, tend to be fleeting.

• The problem is compounded by the fact that timing the market is almost impossible on a consistent basis. Corrections can occur for a variety of reasons. Even when everything appears to be going along merrily, markets often take a breather.

• Navigating around corrections requires near perfect timing, at the top, and at the bottom,  some thing which is impossible to achieve repeatedly. There is no one who has a consistent and well documented history of timing corrections. When you get the beginning right it is only half the equation. To navigate a correction, every investor has to buy back in at some point in time. The lower the market goes, the higher the fear. This prevents investors from buying back in.

 

Bull market corrections : 2004 – 2008

 

Since corrections are inevitable and cannot be timed, what I did was to study past corrections with the following parameters:

How far can stocks drop?

How long can corrections last?

I did a study of past corrections in the bull market from 2004 to 2008.  I have only considered corrections which were greater than 8 %. The year wise corrections were as follows :

 

Date	High	Date	Low	Days	Loss%
14/01/2004	1982.15	22/03/2004	1685.00	68	14.99
23/04/2004	1892.45	17/05/2004	1388.75	24	26.62
24/05/2004	1608.85	23/06/2004	1446.10	30	10.12
AVERAGE				41	17.24
Date	High	Date	Low	Days	Loss%
08/03/2005	2168.95	29/04/2005	1902.50	52	12.28
04/10/2005	2663.35	28/10/2005	2316.05	24	13.04
AVERAGE				38	12.66
Date	High	Date	Low	Days	Loss%
10/05/2006	3754.25	14/06/2006	2632.80	35	29.87
05/07/2006	3197.10	19/07/2006	2932.75	14	8.27
AVERAGE				25	12.71
Date	High	Date	Low	Days	Loss%
07/02/2007	4224.25	05/03/2007	3576.50	26	15.33
24/07/2007	4620.75	21/08/2007	4074.90	28	11.81
15/10/2007	5670.40	22/10/2007	5184.00	7	8.58
AVERAGE				20	5.95

 

The above data shows that bull markets do not go up in a linear fashion. They generally tend to correct between 10 to 15 %. Also, bull market corrections generally last for a period from a month to 45 days.

The corrections in the current calendar year are as follows:

Date	High	Date	Low	Days	Loss%
22/01/2014	6338.95	04/02/2014	6000.90	13	5.33
23/04/2014	6840.80	07/05/2014	6652.55	14	2.75
07/07/2014	7787.15	14/07/2014	7454.15	7	4.28
24/07/2014	7830.60	01/08/2014	7602.60	8	2.91
08/09/2014	8173.90	16/09/2014	7932.90	8	2.95
AVERAGE				17	6.07

 

 

What to expect?

 

• I am aware that the U.S. market has been devoid of a 10 % correction for more than two years. However, I do not think this statistic is comparable. Why? The reason being that we are an ’emerging’ market, and their’s is a ‘developed’ market. Historically, emerging markets are more volatile and are prone to huge swings in investor sentiment. Effectively, for us,  the term ‘investor sentiment’ means ‘FII sentiment’.
• Individual stocks have been correcting on an ongoing basis. The benchmark indices have yet to see a meaningful correction in this calendar year.
• Most investors tend to be unhappy as markets start correcting. The stock market  is the only place where people tend to get unhappy as prices decline. They should, in fact, welcome declines and buy good stocks with a long-term view-point.
• Markets always look easy with the benefit of hindsight. If you think you are investing in the stock market for out sized returns, be prepared for greater volatility as this bull chugs along.
• We have an army of pundits calling for ‘healthy’ corrections. In stock markets, what begins as ‘healthy’ turns into ‘scary’ pretty quickly. It is this fear psychosis that makes money-making in a bull market pretty difficult. I would go to the extent of saying that it is easier to make money in bear markets than in bull markets.
• Charlie Munger has said “I’m convinced that everything that’s important in investing is counter-intuitive, and everything that’s obvious is wrong”.  Stocks have a knack for confounding consensus expectations. If most prognostications think X will happen, you can be relatively sure it wont. So, in short, try to keep guessing what everyone else is expecting. If you do manage to find out, don’t forget to share it with me!!.