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Falling markets: What to do?

Mar 15, 2007

Investors who would have thought of some relief after the broad sell off over the previous few days, must have been indeed left perplexed over the carnage yesterday. The hope of a revival that had once again started to build post the positive ending during the first two days of the week must have been shattered by what happened yesterday. In fact, the losses yesterday were significantly higher than the gains of the first two days put together.With yesterday's decline, the benchmark 'BSE-Sensex' has now lost nearly 15% from the highs it reached just a few weeks ago. What more, while this is just a decline on the broader index, there are individual companies that have lost much more than that. If one were to look at the BSE 'A' group, losses in the region of 20% to 30% over the past one-month are not uncommon.

With markets in such a punishing mode, retail investors tend to panic and the innumerable contrasting views around by the so-called 'experts' further add to the confusion. Hence, here we have made an attempt to answer the same questions of 'why the markets are falling' and 'what to do next' but by not trying to be too complex and sticking to the basics.

Why are the markets falling? Some call it the 'Yen' factor while still others call it the 'reduced appetite for risk in the global markets'. Confused? So are we! Not to worry, let us try and arrive at the solution with a different viewpoint. If we were asked to point out one major difference between the market levels currently and the one in around 2003 when the bull rally was about to take off, it will not take a rocket scientist to realise that price levels vis-a-vis earnings were much lower then as compared to now. Reason? Blame it on human psychology. History suggests that stock prices and earnings haven't really moved in perfect sync with each other. In other words, while on some occasions, earnings move faster than share prices, on other occasions, exactly opposite is the case.

Is your dream fading too?

Just to put things in perspective, between 2001 and 2003, the indices hardly moved while corporate earnings went on rising. This was because the ech bubble of 2000 tech bubble of 2000 had left a bitter taste in the mouth of investors and people had become skeptical of investing in equities. However, the fact remained that there were still quality companies out there that kept on growing their earnings. Slowly and steadily, earnings yield started looking better and it was being felt that stock prices should witness a rise. Please bear in mind that all this while we did not make a mention of global events that were unfolding at that time. This is because if one pays proper attention to the risk-reward ratio and ensures that it is favorable, sooner or later, people would jump on the equity bandwagon and push up the markets.

Exactly opposite seems to be happening currently. As mentioned above, by taking advantage of the favorable risk-reward dynamics, investors have bought so much into Indian equities over the last 3-4 years that stock price appreciation has run ahead of fundamentals (estimated earnings growth). Hence, the risk-reward ratio had started looking unfavorable and the markets looked ripe for some correction. However, all this while, we did not know or rather we did not bother to find out what would cause such a correction. In this case, it was the so-called 'Yen factor' that was or that is widely believed to be behind the current meltdown. The talks about an impending US slowdown have only gone towards aggravating the panic.

Thus, as is evident from the above two scenarios, if one pays close attention to the underlying fundamentals and does not swing between 'unsustainable optimism' and 'excessive pessimism', one need not worry too much about the global events unfolding around him. The only thing required is patience and loads of it.

What should I do next? We believe the current sell off presents a good opportunity to partake in the growth story that is unfolding in the country. All the factors that enable an economy to grow consistently over long periods of time are in place and these should also translate into rising corporate earnings. But the work of an investor does not stop here and company specific research should be undertaken to weed out fundamentally poorer companies from the stronger ones. Particular emphasis should be laid on sustainability of competitive advantages of companies, quality of their managements, strength of their financials and above all valuations. If properly followed, attractive returns over the long-term might be in the offing.

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