GAIN FROM VOLATILITY

The markets have witnessed a turmoil, but there is no reason for small investors to panic. ET Wealth tells you how to tide over the rough seas
Narendra Nathan

The sharp drop in the stock markets has left equity investors gasping for breath and fear is back with a vengeance. The benchmark indices lost 9.3% in the 21 trading sessions in August. In the first week itself, the volatility index, which is a measure of the fear prevailing among investors, shot up from 18.78 to 34.88. What has been especially unnerving for technical analysts is that the benchmark indices broke the support levels (17,500 for the Sensex and 5,250 for the Nifty) they had maintained for almost a year. Should small investors give in to the fear and move out of the stock markets now? Certainly not. Volatility is inherent to the equity markets and investors must learn to live with it. There are bound to be periods of volatility in the journey of the stock markets. This is clear from the erratic movement of the India VIX index. Sometimes the volatility gets heightened, but it eventually subsides. If a 9.3% monthly decline is worrying you, remember that the Nifty had risen by 12.3% in September 2010 and fell by 12% in January this year. Investors should also note that investment opportunities in the markets arise because of this volatility. The way to make money in stock market is to buy into pessimism and sell into optimism, says Raamdeo Agrawal, managing director of Motilal Oswal Securities. There are long-term rewards for equity investors who can get over their volatility phobia. In the past 25 years, the Sensex has witnessed several phases of extreme volatility. There were three major bear markets, when the benchmark index fell more than 50%. However, any investor who held on to his investment during these turbulent 25 years would have generated a cool annualised return of 14.7%. The message: investors must withstand volatility to create long-term wealth. Can small investors ride this uncertainty without taking undue risks? Yes, but they must learn to ignore the short-term noise. We looked at returns from the Sensex in the past 25 years for different holding periods. The longer the holding period, the lower is volatility, as defined by the difference between the high and low returns (see graphic). The probability of loss also comes down when the holding period is longer. For instance, if someone invested in the Sensex shares for any one year since 1986, the probability of loss is 31.67%. If they were held for any five year period, the loss probability declined to 11.2%. If held for 10 years, the probability of loss fell to 1.6%. Mutual fund investors can fight volatility by using systematic investment plans (SIPs) to gain from volatility with the help of rupee cost averaging.

How long will volatility last? According to experts, volatility may continue for a few more quarters, especially till there is clarity about several global and domestic factors. Let us examine these factors that will keep the market on tenterhooks in the coming months. Euro zone debt crisis: Experts believe that the European crisis may take a long time to settle because the inherent weaknesses in the euro system have started to surface. For example, they have a monetary union without a political union and, therefore, the troubled countries cant increase their export competitiveness by devaluing their currency. QE3 hopes in the US: The market participants across the globe will be closely watching the US Federal Reserve meeting scheduled for 20-21 September for hints about the next stimulus package (popularly known as QE3) for the US economy. Even if the stimulus package is announced, analysts have started questioning the efficacy of the proposed QE3. Slowing domestic growth: The GDP grew by 7.7% in the first quarter of 2011-12, the slowest in the past six quarters. What worries analysts more is the serious slowdown in the investment component. Peaking Inflation: There is some scope for good news here, at least for now. Most experts believe that the inflation may start coming down from the month of October. Peak in interest rates: Most experts said that we are close to the peak and with the growth already below the 8% mark, the RBI may not go for aggressive rate increases. EPS downgrade continues: With the first quarter results also falling below the analysts expectations, the downward revision in estimate for 2011-12 continues. For example, the consensus EPS estimate of the Sensex for 2011-12 now stands at 1,195, much lower than 1,260 at the start of the year. Valuation still not cheap: Valuations contract during periods of earnings downgrades. On the other hand, the valuations can also retreat if the earnings go up. This will, however, not happen immediately and investors may have to wait for several quarters. End of policy paralysis: The peaceful resolution of the anticorruption stir has rekindled hopes that the government will move on the pending economic reforms. The decision by the RBI to put out the new banking guidelines is another positive. Where are the markets headed? The consensus is that the current upswing is a pure technical pullback. The market is likely to breach the recent bottom once again, before starting the sustainable upmove. Experts also say that the long-held supports (17,500 on Sensex and 5250 on Nifty) will become the first lines of resistance now. Things are not any rosier on the fundamental side. Domestic factors like taming of

inflation and cut in interest rates may provide positive cues, but slowdown in GDP growth and corporate earnings downgrades will continue to put pressure on the market. The unpredictable global factors are something we have to live with also. What investors should do The best strategy for retail investors is to get in when they are reasonably certain that there is not too much downside from the current levels. If the market comes down by another 10% in the next quarter, it will offer good buying opportunity as domestic macro headwinds like inflation and interest rate will be behind us. Investors should then shift from defensive mode and consider investing in frontline high-beta stocks, says Manishi Raychaudhuri, managing director and head of research, BNP Paribas Securities India. Avoid small- and mid-caps and stick to large-caps as they will be more stable in a volatile period like this and will be the first ones to lead the next bull market, whenever it happens. Avoid stocks where the management is perceived to be corrupt, sectors with high debt, where promoter holdings are pledged or where FCCB payback is due soon. In addition to the traditional defensive sectors such as FMCG, pharma and twowheelers, investors can also consider sectors and stocks that are beaten down but have a clear earnings visibility. Telecom companies have got their pricing power back now and, therefore, should continue to show good results in the coming quarters, says Raychaudhuri. Since Bharti and Idea are making profits now, they are expected to increase these. PSU banks too have suffered the most, bringing down their valuations to much lower levels. And if you are a high risk taker, you can also consider the stocks that are trading below the 2008-9 lows.