The anatomy of bull market corrections

The market may be coming to the end of its four-year-long bull run, but until the evidence appears, we have to assume that this is just another correction in the bull market. Over the past four years, the market (measured using the BSE Sensex) has risen 410% on a cumulative basis. There have been eight corrections of 5% or more from peak to trough. The recent correction is the ninth one.

We have analysed past corrections to help investors to predict what’s in store during and after this correction, if it indeed is another correction. Five points need to be noted with regard to the past eight corrections. First, each of these dips lasted for less than 30 days. Six of the eight produced double-digit corrections — the sharpest one being in May ’04, followed by May ’06. The swiftest decline was in December ’06, which lasted just four days and caused the market to fall 9% from its top. The average fall lasted 15 days, causing 15% damage to the market top.

Secondly, seven of the eight corrections have been V-shaped, with May ’04 being the only exception. The market on that occasion peaked on January 9, ’04, and then moved sideways for four months with a net fall of 4% (from January 9 to April 23). The real dip took place between April 23 and May 17, when the market fell 29%.

The third observation is that the rise, subsequent to the fall, averaged 36%. Only on two occasions was the rise less than 20%. These two coincide with the rise coming after the single-digit corrections in January ’05 and December ’06.

Fourthly, the realised inter-day volatility has usually increased during the descents. January ’05 was the only exception, when the inter-day realised volatility remained unchanged during the six-day correction. The average increase in volatility over the preceding period of rise was about 65%.

Finally, India has always underperformed emerging markets in terms of corrections. Average underperformance has been 7 percentage points. The telecom, metals and consumer discretionary sectors have been the worst stocks to own during a market dip. Conversely, technology, energy and consumer staples have been the best sectors to own. Incidentally, financials and telecom were the best sectors in the rally following the fall over the past four years. Healthcare and consumer staples have been consistent underperformers during these rallies. India has outperformed emerging markets in six of the eight rallies following market corrections

What is unique about the recent decline? This is the first time in a bull market correction that India has outperformed emerging markets. We are not surprised. We argue there were four factors in India’s favour if the market was going through a mild fall in global risk appetite. Firstly, the central bank, through some aggressive tightening since the end of ’06, has built ammunition to counter a crisis in domestic liquidity.

Secondly, the trailing correlation of returns on Indian equities versus emerging markets was lower than in recent corrections. Thirdly, valuations were off their highs and at two-year lows relative to emerging markets. Finally, our proprietary sentiment indicator suggests that market participants were not as bullish as they were at the start of May ’06 or in February ’07. Things can change if the correction in global markets gets more aggressive.

If August 6, ’07 was indeed the bottom of this bull market dip, then it will end up being the smallest correction (of just 7%) in the four-year bull market. At nine days, it will be only the third time that a correction has lasted for less than 10 days, as is the case with the quantum of the fall, which is also only the third occasion of a single-digit correction. The spike in inter-day realised volatility has been sharper than usual. With inter-day volatility doubling from the preceding rally, this spike matches the one that the market underwent in May ’06 (when realised volatility tripled from the preceding period of rise).

At the sector level, the key differences in this dip compared with the past have been outperformance of the utilities sector and underperformance of the technology sector. During the past corrections, the utilities sector had underperformed, while the technology had outperformed. Hence, from a trading perspective, it makes sense to sell utility stocks and buy technology scrips.

Courtesy: Economic Times