Weathering a Correction

By Devangshu Datta | Jan 8, 2011

After months of irrational exuberance, the market is set to go into a period of irrational depression. This is normal — markets are manic-depressive. Stock prices rarely trade at fair value — they either overshoot or underperform.

We have a political crisis of sorts with the 2G scam. We have a sell off in bank and financial stocks that may be a response to the trend of rising interest rates and inflation. We had average to mildly disappointing first half results when rising interest costs impacted corporate profit growth though turnover grew. Most of all, we have a shift in FIIs’ (foreign institutional investors) attitude to negative due to external factors.

There’s no telling how long the downturn could last. It could be a small correction (the Nifty has dropped 5-6 per cent from its recent peaks). It could be a major correction (more than 15 per cent). There may be a v-shaped move with a sharp correction followed by a sharp recovery. There’s no point in panicking. The government is unlikely to fall. Nor does it appear likely that the external situation will turn into a full-blown global crisis.

Valuations are high with the Nifty trading at a PE of 23-plus (5,900 levels) even post-correction. For a value-investor, India is not a buy. It will need to drop to a PE of around 18-20 before it looks comfortable from a value-investing perspective. That would qualify as a deep correction. Waiting for a correction of that magnitude is unlikely to be a good strategy — it may never happen.

On the other hand, increasing equity exposure on a 5-6 per cent downturn is also a dangerous strategy. The market is coming off 33-month highs and it could fall quite a bit further. So, I’d say continue with any normal systematic investment plans that you are holding, but don’t tinker much with equity allocations — either up, or down.

A case for hedging
Rather than passively increasing equity allocation across the board or panicking and cutting down on equity exposure, there’s a case to be made for smart hedging. Increase equity allocations but do so in stocks that are less highly priced and thus, unlikely to be hurt that much in case of a downturn.

There aren’t too many counter-cyclicals available. But sectors such as FMCG and Pharma have not gained as much in the past 18 months as metals, finance, IT and auto. Both FMCG and Pharma have a reputation for holding value through downturns and they could actually gain because of traders switching out of more volatile sectors.

Infrastructure in general has been an underperformer but one would hesitate to recommend it right now because the fallout from the 2G scam could affect not only telecom but other policy-sensitive infra-sectors as well. Enforced higher provisioning for housing mortgages and higher interest costs suggest that housing finance will not be an outperformer in the second half of 2010-11 at least.

Another possible angle, if you wish to be proactive and make money during the decline, is to risk buying deep out of the money long-term options on the Nifty. Due to the fall, January calls at the Nifty 6,300 to 6,500 level, for instance, are available cheap. If the market does recover within the next two months, those call premiums will multiply. Alternatively, buy out of money January puts at 5,500 Nifty. If the market falls, those puts multiply in value and protect your portfolio downside.

The classic derivative trader’s strategy is to set up hedged positions that could gain if the market loses ground. For example, sell the Nifty futures and buy cheap calls at the same time. That way, if the market falls, you gain on the futures and if the market rises, your losses are limited by the appreciation in the calls.

There are more or less risky variations of these methods — using bear spreads, using calendar spreads, etc. The really sophisticated hedge funds will set up market neutral positions, which should gain regardless of short-term direction. However, this is difficult for the average long-term passive investor to even conceptualise, much less exercise.

What the average long-term investor must do is find the courage to continue investing steadily through a possible fall. If you decide to go overweight, do it selectively in less high-priced sectors.

If you want to be pro-active, hedge your portfolio or find some other way to profit from a fall. Just don’t go underweight, or worse still, exit the market.

source;valueresearch