How to prepare for a market correction

Nov 2014: Both the Indian benchmark indices are up by almost 40% from November last year. These are troubling times for the calm investor.

I know, the two sentences don’t make sense. Shouldn’t an equity investor be thrilled that the Indian market, after hobbling along like a hamstrung geriatric for the better part of four years, is now scorching the pavement showing better performance in 2014 than every other stock market in the world?

And apparently, we’re just getting started. Here’s a smattering of expert opinions on what’s in store:

“Bull markets typically last for periods of five-seven years. That has been a typical cycle which Indian markets have always experienced.” – 12 Nov, 2014 Nilesh Shah (MD, Envision Capital)

“I do believe we are in the bull cycle similar from 2003 to 2006-2007. I think the difference this time around is that it is not going to be a service led growth economy, it is going to be domestic led economy and that will be very powerful in terms of earnings.” – 12 Nov, 2014 Andrew Holland (CEO, Ambit Investment Advisors)

“Downside risk in global markets is limited and Indian markets could see 5-10% upmove in next 12 months” – 12 Nov, 2014 Robert Parker (Senior Adviser, Credit Suisse)

“We should definitely brace ourselves for a much better year next year. It is difficult to give a number because as derivatives traders. Hopefully, by June 2015, we should see those kind of levels around 9000,” – 11 Nov, 2014 Tushar Mahajan, Head of Derivatives, Nomura

Unlike the last three years, UBS expects FY16 and FY17 earnings growth estimates of over 15 per cent to be met. Nifty target of 9,600 is based on top-down expectation of 15 per cent earnings growth in FY16E and 18 per cent growth in FY17E (on a base of 13% in FY15E) – 11 Nov, 2014 Someone at UBS

Maybe it’s to do with the fact that my first taste of equities came during frothy times of the bull market in 2006, where experts were all similarly unanimous as markets made new highs every week. This was followed by declines, some drastic, some gradual. Or the fact that of all the reading I’ve done on the topic, the central tenet that has stayed with me and forms the core of the calm investor  investment philosophy is that the only thing in your control is the price you agree to buy at. This has probably made me much more sanguine about market declines as opportunities to “be greedy when others are fearful”.

The opposite scenario however, introduces a few doubts, makes me uneasy. As  individual (large-cap) stocks show gains between 30%-90% in under 12 months, as every possible positive expectation and hope gets priced in well in advance of earnings improvement, it’s tempting to ask the question “Should we hold, or should we fold?”

As always, it helps to go back to what people much wiser have already thought and thankfully, written about.

Exhibit 1: Snippet is from Warren Buffett’s 2000 letter to shareholders of Berkshire Hathaway:

On sharp market rallies…

The line separating investment and speculation, which is never bright and clear, becomes blurred still further when most market participants have recently enjoyed triumphs. Nothing sedates rationality like large doses of effortless money. After a heady experience of that kind, normally sensible people drift into behavior akin to that of Cinderella at the ball. They know that overstaying the festivities ¾ that is, continuing to speculate in companies that have gigantic valuations relative to the cash they are likely to generate in the future ¾ will eventually bring on pumpkins and mice. But they nevertheless hate to miss a single minute of what is one helluva party. Therefore, the giddy participants all plan to leave just seconds before midnight. There’s a problem, though: They are dancing in a room in which the clocks have no hands.

Exhibit 2: Snippet from Warren Buffett’s 1987 letter to shareholders:

On selling investments that have run up significantly…

…we do not sell holdings just because they have appreciated or because we have held them for a long time. (Of Wall Street maxims the most foolish may be “You can’t go broke taking a profit.”) We are quite content to hold any security indefinitely, so long as the prospective return on equity capital of the underlying business is satisfactory, management is competent and honest, and the market does not overvalue the business…

And three investments in question, none of which they had any intention of selling

The takeaways, I think, are applicable to all calm investors,  even if our portfolios might look similar to the one above, except without the ‘in $ millions’

1. Unrealistic expectations and groupthink are real determinants of stock prices. They bring in all kinds of speculative money driving up prices of good and bad companies alike. And no, there is NO WAY to foretell exactly what will reverse that sentiment. However, whether you choose to keep participating (buying) in such a market is in your control. Do not join a buying frenzy
2. But simply because there is a lot of irrational buying happening, should one sell their quality stocks? Yes and No. If you’ve identified promising (not speculative) alternatives, take the gains but otherwise, stay invested

That being said, the question I posed myself was, what if the Sensex rises another 3,000 points? 5,000 points? over the next six months. At what point (if any) should one batten down the hatches and sit on cash? The big risk of not participating in the market is that you’re likely to find your will breaking just as new highs are reached. So is there a way to decide when to “sit out”? That’s the topic of the next post…

 References:

Berkshire Hathaway 1987 letter to shareholders – berkshirehathaway.com

Berkshire Hathaway 2000 letter to shareholders – berkshirehathaway.com

Global volatility could put India on terra firma – Business Standard

Expect Nifty to touch 9,000 by June 2015 – Economic Times

UBS sees NIFTY at 9,600 by 2015 end – Business Standard