The big correction

SMARTSHARE

The last two weeks have seen a major correction across global markets. In India, the major indices fell by over 20 per cent from their all time highs. Stocks in sensitive sectors such as metals fell by even larger amounts.

This was because most global markets were massively overbought and quantities of speculative cash flowed out in a rush. As far as India was concerned, by May 25, the FIIs had sold Rs 5,378 crore.

After the derivative-settlement, we're likely to see conspicuously lower volumes. It would be tempting for long-term investors view this as an entry opportunity and get back into creating systematic positions.

Indian mutual funds appears to have taken that view of the situation "" they have bought Rs 6,522 crore while the markets fell. This also suggests that there has been very little redemption pressure.

So, is the correction over? If it is, we could suggest re-entry across a broad selection of stocks. One method would be to buy into index funds through some variation of a systematic investment plan that gradually averages down. The arguments in favour of doing something like this have already been articulated by many people.

What if the the correction is not over and we head into a long-term bear market? Technically speaking, the average Indian bear market tends to see retractions of 30 per cent plus from the previous top and it tends to generate price losses for periods of 12 months or more.

This bear phase has lasted barely two weeks and it's created a pullback of about 20 per cent. The previous bull-run lasted at least two years, even longer if you ignore the one-session crash of May 17, 2004. In terms of momentum, a bottom at between 2,000-2,500 Nifty levels seems more likely than a full-recovery from a 2,900-dip.

Nobody should gamble on catching an absolute bottom so this is not a completely convincing reason to avoid investments.

However, the Indian market's fundamentals still look stretched despite the sell off. Despite the FM's brave pronouncements about strong fundamentals, the financial environment has got worse in the past five months.

There's clearly upward pressure on interest rates and we're now resigned to crude prices ruling at $70 per barrel rather than at $60. When you factor in the lagged effects of these two variables alone, earnings growth is almost guaranteed to slow down and the trade deficit will get worse.

GDP growth may remain strong but that is no guarantee of corporate profitability if interest rates rise. Despite the correction, the Nifty is up about 12 per cent since January. I don't think the fundamentals have improved since then.

At 3,200, the Nifty has an average PE of 18.

EPS growth projections for 2006-07 are in the range of 18-20 per cent. That means a forward PEG ratio of 1, which is on the edge of safety. Normally Indian bear markets have tended to bottom with single-digit PEs.

The projections are gloomy. If the market recovers with a bang, we're back in a dodgy situation of over-valuation. If the markets continue "correcting", we may see lower prices through the rest of this fiscal.

Averaging down is all very well. But it requires deep pockets and lots of patience. If you've got the requisites, try the index SIP route.

It's as good as any other since you're betting on something as broad as "fundamentals".