Part I – The anatomy of the bear
As I sit to analyze the kind of stocks and sectors one should be buying into at this point of time with a medium term perspective it is important to analyze the anatomy of the bear market. In order to do this I would first go back to the last phase of the bull market, which was the main phase of excesses and extreme euphoria.
Epilogue – The big blow off – This phase started from the month of September 2007 and lasted till January 2008. This was the period in which the Sensex went up from around 14500 to 21000. This was the time period in which valuations went up ridiculous levels, there was a huge deluge of money from hedge funds, there was extreme leveraging and retail investor frenzy was at its maximum. At the risk of repeating this was also the period in which even most professional fund mangers could not see the fact that the bubble had become so big that it had to burst. The genesis of the last phase of the bull market lay in the beginning of the rapid monetary easing by the US Federal Reserve subsequent to the start of the mortgage crisis and the beginning of the emergence of the financial crisis in the US and Europe. As a very good friend of mine puts it “ This was a phase where as the easing cycle started a large number of hedge funds thought that the liquidity is now going to over flow from a glass that was already full, without realizing that there was actually a very very big hole in the glass”.
This was the phase of the market where fundamentals were of no relevance and companies with grand plans and worst cash flows outperformed most of the other stocks. In this phase the BSE Mid cap index went up from 6000 to 10000 level a gain of a whopping 66%.
I will break up the bear market of the last 15 months into three parts
PART 1 – The end of Euphoria – January to September 2008 – This was the first phase of the bear market and was pre Lehman Brothers collapse. In this phase there was a sudden reversal of liquidity flow and was also the phase in which commodities kept on rallying ( till around July to September depending on the commodity we are talking about) and was the phase in which inflation was a bigger concern in most emerging markets and euro zone. In this phase there was a very rapid increase in policy rates by central bankers all over the world as crude, copper, steel prices etc kept on rallying in the backdrop of a slowing global economy and reducing liquidity. This was the phase in which most market participants underestimated the scale of the problems in the financial systems in the Western economies and in general loss levels were underestimated. Economies all over the globe kept on moving from bad to worse in this period. However this was also a period in which lot of emerging market economies were believed to be relatively insulated and their suffering would only be due to collateral damage. This was the time period in which both mid cap and large cap companies fell in value. However this was also a phase where there was some sort of distinction in the markets between companies that would be relatively insulated from the slowdown effect. Companies that had good order books or a good execution history were relatively spared in the carnage. This was sort of a normal bear market phase in which markets fall by 25-30%.
In this phase hedge funds faced huge redemption pressures and most emerging markets saw significant outflows. In this phase which lasted till the middle of September 2008 the Sensex fell by 30% and the BSE Mid Cap index by 45%.
PART II –End of liquidity and execution disbelief – September 2008 to January 2009 – This was the period in which financial institutions in the USA started collapsing. Although smaller companies were collapsing the big one like Lehman hit everyone on the head. This led to liquidity totally drying up globally. The three month LIBOR shot up to nearly 4%, yields on US Treasury bills became virtually zero as capital preservation became the prime focus. This was the time period in which there was forced selling from a large number of FII’s and Hedge Funds due to the virtual collapse of the financial system in Western economies. There was extreme panic in the month of October/November 2008 and led to the formation of a panic bottom in the markets in October 2008. This was also the phase till be beginning of December 2008 where there was a virtual collapse in mid cap stocks although large cap stocks started stabilizing after making the panic bottom. In this phase valuations were of no importance. There was huge execution disbelief and due to the liquidity crunch the market started doubting the execution ability of projects that were already awarded. In this phase order books lost their relevance and most market participants started believing that things will never improve. This was the time when central bankers globally started cutting rates aggressively and also started pumping huge amount of liquidity into the system. However the fear was so high that nothing seemed to have any impact. Markets started to improve from the beginning of December before Mr. Ramalinga Raju burst into the scene in the first week of January.
In this phase companies with high debt levels, requirements of refinancing, high forex exposure, requiring large working capital fell the most.
In this phase the Sensex fell by another 35% and the BSE Mid cap index fell by another 40%.
PART III – Total Disbelief and the lack of confidence – January 2009 to Beginning March 2009 – Even as markets had started stabilizing from the beginning of December 2008 the Satyam scam broke out and this combined with the process of change in regime in the USA and a constantly deteriorating scenario in the economic scenario globally led to the virtual “Falling off the cliff” of the markets, specially on the mid cap space. This was the phase in which no one wanted to own any mid cap stock and even large cap stocks with suspect accounting standards or suspect managements saw their stock prices crashing extremely badly. This was a phase in which most Western economies stock markets made new lows and most emerging markets held on to their October lows in term of large cap indices. However mid caps continued their free fall. This was the phase in which I believe that mid caps finally bottomed out as investors who were still holding out finally lost patience and sold these stocks at dirt cheap valuations. This was the phase which was the total reverse of October 2007 to Jan 2008 where investors just wanted out of mid caps. This was also the time in which investors wanted to stick to the bluest of blue chips and risk perception was the highest.
In this phase companies with suspect management practices, suspect accounts, commodity companies or those with exposure to the Middle East countries fell the most.
In this phase the Sensex fell by around 23% and the BSE Mid Cap index fell by around 30%.
In the second part of the article I will talk of what are the segments of the markets to buy into now.
INCIDENTLY MARKETS ARE LOOKING OVERSTRETCHED IN THE NEAR TERM. SHOULD GIVE UP SOME GAINS.