Making sense of losing streak
Knowing the difference between a correction and a change in trend can help investors take wise decisions

From the way 2018 began with a mid-cap underperformance, it seems phrases like “southward correction”, forgotten by the Street in 2017, would be remembered often this year. Surely, a corrective phase is tough to live through, especially when one’s mind is vexed over the notional loss suffered. One tends to compare the fallen stock with the peak it had hit a few days or weeks ago, and starts ruing not selling in time. In the anxiety to not to lose more, investors often make the most foolish decisions.

The best way to control such anxiety is to understand the difference between a “correction” and a “change in trend.” A correction typically happens for a short period. It leaves a sharp dent on stock prices followed by a phase of consolidation before an attempt is made to scale a new high.

However, a change in trend vastly differs from this. In this, prices move south for a much longer period, at times for years. In a downtrend, the stocks that suffered a sharp dent tends to lose more value over a period. Such a trend change ultimately ends up in an investor aversion for owning that asset class for a long time.

Today, we see such aversion in debt products, what with interest rates coming down to appallingly low levels over a period. Another case of change in trend is what gold underwent. After remaining range-bound for more than 20 years, gold started climbing up from 2005 and kept up the momentum till 2013. After that the precious metal has reverted to range-bound moves, for four years now. From being bullish, the trend in gold has changed to being neutral, or range-bound. How long will this trend last is hard to predict, but it may stay in this state for another decade, or even more, as happened between 1985 and 2005.

In equity, a change in trend occurs when the fundamentals of a sector or a country changes. Take the pharma sector. Until late 2014, most pharma stocks were outperforming the broader market indices. But after that they have mostly been underperforming. Because of regulatory issues at home and abroad, pharma firms have lost their pricing power, which they may not get back anytime soon. While their bottom lines may grow, they will never get the same relative valuation they had got in the past.

To make out whether stock values are falling because of correction or trend change, one has to know the underlying reasons. Only when this reason is known an investor or trader can make a rough estimate of the quantum of correction. If the quantum is roughly assessed, the anxiety levels will also come down.

A correction can take place for many reasons. But let us see two reasons. First, profit booking. After a sharp run-up in a stock, investors tend to book profit by selling the stock, which leads to a correction in its price. Such corrections are short-lived and tend to take a stock in sideways directions rather than leaving a sharp dent on its value.

The second reason for correction comes from unmet expectations. When the earnings estimates are not met, investors tend to sell that stock. We see such corrections during the earnings season. This kind of correction is often sharp, as it is accompanied by offloading by investors who had taken short-term positions in the hope of good earnings.

But these are again short-lived, as another set of investors eventually comes to buy the stock in the hope of better earnings in the next quarter.

So, it helps to make a good guess or estimate about the extend of likely loss in a correcting stock. In a stock market, buying a wrong stock is a mistake, but selling a good stock untimely is an unpardanobale mistake, as many stocks tend to multiply the returns for a patient investor.

The best way to arrive at a rough estimate, or guesstimate, is to see the extent of correction an index or a stock has seen over a long period. The long-term here means at least two bull and bear phases. Let’s first take the case of Sensex, as it had been in existence long before the Nifty came into being. On January 2, 1991, the Sensex closed at 999 points. This was when the infamous bull run, led by ‘big bull’ Harshad Mehta, had just started. At the height of the bull run, the index touched a high of 4546, in April 1992, before the securities scam broke and took the market down with it.

As the bust ended, the Sensex touched a low of 1980 points on April 27, 1993. From the peak of April, the Sensex corrected 56 per cent. But the gains, from January 1991, was still 98 per cent. Hypothetically, anyone who had bought the index (there were no ETFs, so it was not possible to buy the index) almost doubled his money in a little more than two years.

This means that even the worst scam could erode only 56 per cent value of the equity asset class. Remember that probability of a scam hitting the market is negligible today because of robust regulatory watch. And a scam is the worst that can happen to an equity market.

Now let’s look at the recovery part. After touching a low of 1980 points in April 93, the Sensex started an upward journey and touched a new high of 4643 on September 12, 1994. For an investor who had, hypothetically, clung on to the index till 1994, the return would be 364 per cent in just over three years, from 1991.

In the last nine years, except in 2014 and 2017, the index had witnessed more than three corrective phases in which it lost anywhere between 5 per cent and 14 per cent, only to rebound within months.

Extending the logic, even if the Nifty today corrects more 10 per cent, should an investor feel panicky? The answer is no, if you are one holding the index ETF. However, for those holding the Nifty stocks, the impact is different; a 10 per cent correction in the index could mean a 40 per cent correction in stock prices and the recovery may or may not be as sharp as the fall, and in some case, a rebound may take years. For such investors, there is another way to figure out what might happen to their wealth.

The basic work, as always, starts with reading about the developments in the sector. Then check out the long-term price charts of the stock to see the extent of its decline in past corrections and bounce-back. If nothing much has changed fundamentally, then, give or take a few percentage points, expect that the stock will correct to a similar extent.

A slightly more sophisticated way would be to make a point to point comparison of the index and the stock during the various corrective phases. But such methods are useful only in large-cap stocks having a long price history. Mid-cap stocks, which have seen a rally because a sector has got re-rated—like NBFC and consumption stocks in the current rally—don’t give reliable results in this method.

Unfortunately, small investors mostly have exposure to mid-cap stocks. In such cases, investor can check out the stock’s performance in the current phase of the bull run that has started in 2009.

(Rajiv Nagpal is consulting editor, Financial Chronicle)