Waiting for a correction to invest? Think again

With the Sensex scaling 18000, subprime now seems to be a distant bad dream. However it was not too far ago when investors across the world were running helter skelter hearing subprime. It was then that the Fed like knight warriors came to the rescue by cutting the interest rates by 50 basis points. This action seems to have wiped all the subprime mess that has taken several years to build up. What did investors do in the meantime? A lot of people waited, waited and waited for the markets to correct even further. Nobody dared to enter the markets at 15000 levels or for that matter even at 14000 levels. At the same time several pundits were predicting the next big correction. Well the markets in the meantime zoomed across and in the process most people missed the boat like always. Well the markets have a very high probability of correcting now but the moot point here: More money is lost in waiting for corrections, anticipating corrections than in corrections itself.

Waiting for corrections to happen has been a reality of the markets and all market participants are guilty of such practices. I am not saying it’s a bad thing but that short-term corrections and sharp up moves are very difficult if not impossible to predict. How many people would have predicted the 600-point rally after the Fed rate cut? Charles Ellis’s Investors Anthology has a very apt quote which was part of weekly staff letter (1951) of David Babson & Company “It must be apparent to intelligent investors who if anyone possessed the ability to do so (read - forecast the immediate trend of stock prices) consistently and accurately, he would become a billionaire so quickly, he would not find it necessary to sell his stock market guesses to the general public”

There are both rumors and reports that the Sensex will touch 20000 soon and 25000 in the next 6-9 months. The logic is that if China can be valued at rich valuations of 45 plus why couldn’t the second fastest growing economy valued at 25 or for that matter 30. Sensex company’s earnings are predicted to be around Rs. 860 by end of the current year and Rs. 1000 by 2009. What would be the index levels with such earning levels? Your guess is as good as mine on this one.

So what should people do in such situations?

1. Firstly rebalance your asset allocation and have clear investment rules stating rules on when to buy and sell. If you are high on equity and have made sizeable profits, it means move into cash or debt as per your investment strategy. After a correction, when you are high on cash you can move back into equity. However if you are low on equity, then you should stagger new investments on every fall. Now what happens if there are no falls? No market could be insulated against falls and there will be falls along the way. I am not sure how looking at forward or trailing PEs could help perfectly estimate overvaluation or undervaluation. It could be an indicator along with several other parameters including volumes, technical data and F&O information. But these are not sacrosanct parameters and more often than not, their interpretation is wrong. And by the way if there are no falls then you can only stagger your investments unemotionally through regular investments in stocks and mutual funds.
2. Wait for the significant correction to happen. This essentially means timing the market and this is again a very difficult thing to do. How do you know what is the lowest level and how long should you wait? Is the rally post the correction a realistic one or is it just a dead cat bounce? There are several questions to be understood and answered here and how many people are gifted enough to consistently get this exercise right. Warren Buffet is often quoted in almost every second column but few people have the habit of being patient. Finally what does being patient mean? In a structural bull run, how patient can a person really be with the index conquering new heights and whether it is a wise strategy.

Our market currently faces three key Risks

1. An untoward event in the global situation due to subprime or any other possible theory has the potential to bring markets down.
2. Increasing Oil and Commodity Prices might exert an upward pressure on inflation and interest rates.
3. Domestic Political Situation leading to an early election might also cause nervousness in the markets. However this is the least crucial of all risks as our economy has gathered the momentum to clock high growth rates with any political party running its affair (except for if the Left comes to power which at least in the current scenario looks highly improbable.

Indian Investors will be surprised to know that there are a lot of US Money Market Funds that have invested in subprime debt. Also there are several other financial institutions that have huge exposures to subprime debt. According to a recent Bloomberg column, AIG, the world’s largest insurer and reinsurer, had almost around one third (33%) of its USD 104 billion networth invested in subprime related securities. And there are several such insurance companies with subprime exposure of 3 to 20% of its networth. What would happen if one of these institutions or some large hedge fund with huge subprime exposures collapse like the one we witnessed in August this year? Surely our markets will come down and decoupling that is a buzzword these days might seem like a joke.

- Amar Pandit

The author is a practising Certified Financial Planner. He can be reached at amar.pandit@moneycontrol.com