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History is the best stock market teacher

by Money Puzzle   ·  May 20, 2022   ·  

History is the best stock market teacher

by Money Puzzle   ·  May 20, 2022   ·  

Photo by Liza Summer from Pexels

What a week it was for global stock markets!

Gains of the last year were given up in the matter of a month. The gyrations of volatile price swings in equity stocks were literally felt the world over. Diversified indices which seemed invincible in 2021, fell with an unexpected weakness from the start of 2022. Where exposures were more narrow – ie tech and commodities – the swing has been even sharper. 

A quick recap

All of this chaotic activity in equity markets, ironically, is the most logical reaction to decisive liquidity tightening by central banks (most relevant of them the US Fed) across the globe. Tightening does not refer to pulling your belt and squeezing the waist, but in a sense is just that. It’s the jargon we use to describe a sharp rate hike by central banks in a bid to pull back easy money which is available to people at seriously low (or nil) cost (read as interest rate). In today’s context, the tightening is accompanied by a hard stop on the quantitative easing or basically, printing of free money and that’s causing even more pain.

The pandemic brought economic activity to an abrupt halt and central banks moved in to save the day by making money available quickly. This meant, dropping down interest rates as much as possible – almost 0% in the US. Imagine that banks had access to money at no cost and individuals could now borrow from these banks at practically no cost. Plus, there were plenty of social benefits doled out to the public by governments across the world, including ours. All of this excess money went into buying more stuff and also investing in assets. For decades, economists have time and again informed us, laypeople, that, when ‘free’ money starts buying things, inflation or price rise won’t be far.

Now – the world’s largest economy – the US – is struggling with an inflation rate of 8.3%, while its Fed rate stands in the range of 0.75%-1%. A sharp price rise is not good for any economy as it eats away the value of its currency. The US is being spoken about a lot because basically, with the most amount of its sovereign currency floating around outside of the country, it is exporting that price rise to the rest of the world.

In India, we have just seen the annual price rise spike up to 7.8% in the latest reading. It means that ‘stuff’ is now expensive, savings are hence, likely to fall and so is consumption. When that happens, GDP – the indicator of economic growth and partly made up of household savings and consumption – will fall. The trickle-down effect, apart from decreasing the value of money, can range from lower corporate profitability to higher unemployment and a fall in asset prices. None of it is good news.

Phew! That’s quite the summary and sounds scary!

Why look at the past?

While all this was unfolding last week, I was happily driving through the heatwave in North India with my family. One of our stopovers was the Golden Temple in Amritsar, a place of worship and also a place of historical significance. Until you understand the pain and anguish of the massacre that shook the Sikh people in 1919, you may not be able to appreciate the urgency with which many of them have left India for refuge in the West.

Stock market activity is no different, history is often an important pointer in understanding market reaction and history tells us that short term excesses in the market are punished severely, but also that quality always recovers from such shocks.

Who remembers or rather knows about the big ‘tech-led’ market crash in 2000? The Nifty 50 had gained 100% or doubled in a span of two years from 1998 to 2000. Doubling of a benchmark index in a short period like that is in every way and form an abnormal profit or excess. Abnormal excesses in markets are bound to correct – either sharply or over a long period of time. In this case, the correction that ensued lasted 3 years till 2003 and the index lost around 45% of its value by then, with a lot of sharp volatility in the interim period.

While the index had doubled, the darling ‘tech’ stocks had gained multifold. Infosys Ltd, a highly regarded blue-chip company, saw its stock price go from Rs 11 in January 1999 to Rs 170 in March 2000, a gain of 15 times in a year! Such extraordinary gains are not sustainable. At the time, you may think they are and there are many an explanation that comes up to justify the price rise. In reality, it’s not possible that stock gives such returns year after year and the same holds true for the market as a whole. The stock price of the company fell to a third of its peak price within the next year.

Truth is that IT stocks were considered invincible in that period and nobody believed that anything untoward could happen. What also happened globally in developed and emerging markets is that managed funds which were IT-focused lost practically all their value, many shut down and never returned investor money.

What seemed too good to be true, ultimately was.

The last two years have been somewhat like that for the stock markets, too good to be true.

While the pandemic surged through the globe causing economic damage as much as it caused a health emergency, stock markets (and other asset markets like cryptos too) kept moving upwards, shunning the potential risks to economic growth as a result of a long drawn global pandemic. False support thanks to a temporary parachute of monetary aid and low-interest rates, just made the situation seem like a never-ending party. With every new stock market high – both domestic Indian and US indices touched their all-time highs in 2021 – there was much cheering, followed by a desire to keep walking in further and adding more exposure.

The short term experience became the universe of outcomes rather than just one of the possibilities.

That’s where history helps. The euphoria and crash between 1998 and 2000 with tech companies weren’t too different when it comes to experience and outcome.

Where are you now?

Whether it was FOMO – Fear Of Missing Out or TINA – There Is No Other Alternative, which drove the retail investor frenzy in stock markets, hardly matters. Fact is, there were roughly 41 million Demat active accounts in India as of March 2020 and now that number stands at nearly 90 million as of March 2022.

More demat accounts were opened in these two years than ever before!

Did retail investors suddenly understand the benefits of long term equity investments in these years or was it more the chase for quick return after witnessing the sharp recovery post the March 2020 crash?

The latter seems more likely. However, just as exciting as it was to buy a stock or open a Smallcase account, only to see gains clocking in, it is unnerving to invest more money in a downward trending market. As history has shown us, the downward trend doesn’t always last just a few days, it can go on for years.

If you are one of those who made stock market earnings your primary source of income without an accumulated cushion of gains, you may be seeing red now as stock prices have corrected 20%-30%-50%. The disillusionment is exaggerated if you are trading in the futures and options market or have borrowed to invest in equities.

Social media influencers, YouTubers and several other self-proclaimed stock market experts, gained a lot of prominence talking about how to make money buying stocks. Now that markets are correcting, the chatter has shifted to debt investments and pension investing rather than ticking IPOs and talking about trading apps.

Back to you. If you are stuck in downward trending markets and unsure what to do now – here are three things you can focus on as the correction continues. If the correction stops and the markets turn around, by doing these three things, you will only be better placed to take advantage of the rising prices.

1. Sieve out the poor quality

The most important aspect of stock market investing and perhaps the least in focus is QUALITY. If you buy poor quality stocks, no matter how much the market rebounds, you may not make any money. If you buy good quality stock, no matter how much it corrects, it will always rebound.

Amazon.com Inc was nearly a USD 100 stock when the markets were at a peak in early 2000, it crashed all the way down to below USD 6 in late 2001. However, a persistent management focused on generating profit didn’t let the stock market chaos distract it from the work ahead.

Many poor quality stocks crashed and the companies behind them went bankrupt. The story of correcting prices in India’s new-age tech companies is not very different. Several of them listed recently, post an IPO with much fanfare, only to deliver deep losses to retail investors.

Hence, focus on quality; this is a good time to get rid of all inferior quality stocks, growth at any price was always going to be a dangerous mantra!

2. Diversify

Take this as an opportunity not just to sell the poor quality but also to build a good foundation for your stock portfolio by adding stocks from across industries rather than just following the herd. Diversification is a way to de-risk your portfolio.

You may have noticed that fintech stocks and banking stocks are correcting sharply; sector beating is common, and if you have too much in one sector, the return volatility in your portfolio can become unmanageable.

Add stocks from across sectors, you can always keep a higher weight for sectors you prefer but don’t over-allocate.

3. Put a plan in place

The euphoric investment sentiment of a few months ago took very little time to disappear and be replaced by fear. This has proven yet again that markets are unpredictable and while triggers vary from time to time, the experiences and outcomes often remain the same.

Instead of trying to get ahead of the market and catch the latest high or escape the low, it’s best to invest small amounts regularly and then remain invested for long. This requires you to have a plan to invest your surplus every month, month after month. This way you will be able to invest at the lows and also gain from the highs without much ado.

Equity investing requires a bit of awareness about business cycles and market cycles, coupled with a lot of regular discipline. You should be aware of what is possible in this realm even if you think that at the moment none of that severity is probable. At the same time, you should be aware so that you don’t break your discipline; a decadal perspective on stock prices is very different from what can happen in a year or two.

History is definitely your friend when it comes to the understanding that neither the euphoria nor the fear in stock markets lasts forever, the key really is for the investor to last as long as possible through these ups and downs.

Happy investing! Do write your comments or mail us if you liked what you just read.

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