IN A FALLING MARKET ......

 COURTESY : THE BUSINESS LINE.

Pranay, who started investing in equities in mid-2010, is worried. With almost 25 per cent shaved off from the BSE Sensex's November 2010 peak of 21,005, the markets now seem to be on a downward spiral. Pranay's portfolio of blue-chip stocks, acquired after a good deal of research, has also taken a sharp knock. Adding to his unease is the opinion in some quarters that the markets have entered a bear phase. Unnerved, Pranay is thinking of liquidating his equity investments to cut losses, and also permanently staying away from the stock market. Is this the correct decision?

What's a bear market?

First, let's consider what constitutes a bear market. A sharp, prolonged decline in the price of assets (stocks, in the case of equity markets) is a defining feature of a bear market. Though not cast in stone, it is generally believed that when equity markets fall over 20 per cent from their peaks, they are in bear territory. By this yardstick, the Indian markets, having lost more than a fifth of their value since last November, could be said to be in bear zone. However, this fall has neither been continuous nor prolonged (as yet), and has been interspersed with some strong comebacks - the latest in July when the Sensex closed above the 19,000 mark. So, strictly speaking, our markets still have some way to go (down) before being categorised as being in the ‘bear category'. That said, a growing sense of despair - another leitmotif of bear markets - is beginning to make its presence felt in the Indian markets, with many participants having a negative outlook on the future direction of the bourses. Such pessimism is often self-feeding and results in spiralling market declines.

Bear markets are different from ‘corrections'. The latter are relatively minor declines in prices, do not last long, and mostly serve to remove froth (unjustifiable price increases) out of overheated markets. Bear markets, on the other hand, result when fear sets in among a large section of the investor community about the future prospects of the economy and companies.

The trigger

A deterioration in economic fundamentals which impacts the prospects of companies is often the trigger for bear markets. For instance, the recent sharp market dip in India has been precipitated by a steep rise in raw material costs, rising interest rates, global economic uncertainties, and fears of a domestic slowdown. The uninspiring results posted by India Inc. in the recent quarters have also contributed to the pain. With panic setting in, even stocks of companies which are otherwise sound are beaten down hard. During the last major bear market witnessed by the Indian bourses in 2008 and early 2009, the Sensex tanked from around 21,000 to below 8000, dragging down in its wake the bluest-of-the blue chips.

Dealing with it

Bear markets can have a profound detrimental effect, both financial and psychological, on investors. Some such as Pranay in the example above lose all appetite for investing. However, this may not be an optimal decision, for often in adversity lies opportunity. Market cycles turn, sometimes slowly but surely and bear markets, once they run their course, inevitably give way to revivals. Given that equity as an asset class has proved itself to be among the best wealth-generators over the long-term, investors would do well to continue allocating a portion of their assets to equity. For the discerning investor, bear markets may provide attractive opportunities to pick up good stocks cheap. Being greedy when others are fearful can be quite profitable in the long-run.That said, it may be impossible to predict when the market has hit rock-bottom. A bear market can be like a falling knife, and attempting to catch it could leave your hands bloodied. So, instead of attempting to ‘time the market' and investing a lump-sum at a perceived bottom, investors may be better off adopting a policy of staggering their purchases and buying on dips. Unit cost averaging (reducing overall average cost by investing same amounts periodically to buy more at lower rates and less at high rates) can be put to good effect in bear markets. However, caution needs to be exercised. Not everything available cheap has value. Some questionable stocks, which may have also run up sharply in buoyant market conditions, will invariably be beaten out of shape in bear markets. Such stocks may be permanently de-rated and would likely languish even after the market revives. There are umpteen examples of stocks which never revived from their 2008 and 2009 lows. So it is essential to choose your picks carefully in a bear market; the operative phrase being ‘invest only in fundamentally sound companies available at a discount.' Also, Pranay's idea of selling off his blue-chip stocks to cut his losses may not be a good one. Akin to tough people, good companies will invariably tide over tough times. Difficult as it may be in a falling market, as long as Pranay holds on to his blue-chips, his losses would be unrealised and there is a good possibility of it being recouped in the future. Once sold, notional losses become real and cannot be recouped. That said, if Pranay had initially invested in questionable stocks without adequate research, he may be better off making a switch, by selling the duds and buying into good stocks. The latter are likely to revive faster and stronger when the market's fortunes change for the better.