Friday, October 30, 2009

Correction in Stock Markets

“Correction” is a relatively well known word in stock market circles and for someone who does not understand clearly what it stands for, this article might help finding what it is.

Deriving the Definition / Meaning

The definition for “Correction” lies in the word itself, but one just needs to associate that with stocks markets. The standard dictionary meaning for the correction is,

- an action to rectify something
- an action to set right (Correct) the anomaly
- to set right an error or misunderstanding

So, if rectifying something is termed as correction, many would be wondering what went wrong in stock markets to rectify. Here is my explanation.

Stock prices usually discount the future earnings into its present price. People buy stocks at a particular price expecting that the company’s earnings (EPS) would stand at a specific level which they call it as forward earnings. Sometimes they buy based on the present valuation as well. SENSEX levels just imbibe the same concept. Let me explain in detail.

Consider SENSEX as a company just like State Bank of India. Usually SENSEX trades around the PE ratio of 21 -22 at peak valuations (SENSEX PE is calculated by adding the 4 quarter earnings of all the 30 SENSEX companies) and sometimes in a crazy bull market it even goes above 25.

People expected that the Financial Year 2009 (FY2009) SENSEX EPS would stand around Rs.850 – 900. If we multiply the PE and EPS (21*850), we get 17850 and that’s the SENSEX target Indian Stock market was trying to achieve. So, stock prices shoot up from the March lows of 8000 to 17100 and we had a sharp rally based on the prediction that SENSEX EPS for FY2009 would be about Rs.850 - Rs.900.

Had the companies announced good second quarter results, there would have been no problem and the SENSEX might have moved up and even the FII’s (Dawood Ibrahim’s of Indian Stock Market) would have been confident about the India growth story. But since companies by and large announced muted and negative results, market realized that the FY2009 EPS would not be what they actually thought (Rs. 850) and it would be less than that. So, market realized the mistake that it took the SENSEX too far (Ahead of Earnings) and wanted to rectify the mistake or error which we call it as “Correction”. We can see number of corrections happening in the Indian Markets since 2002 in the following graph.

Foreign Institutional Investors (FII) started selling the equities (Domestic instituations followed and will follow as well) and market has declined to the SENSEX level of 15896 as of 30/10/2009. It would correct itself till what market decides the right EPS and PE in the short term. Please see the following graph to understand the relationship between net inflows from the FII's and SENSEX.

So the “correction” can be termed as a self provoked mechanism by which market automatically rectifies the errors or excesses committed by its participants. Historically if the decline is 10 percent or less then people term it as “corrections” otherwise it would qualify for a “Market Crash”.

My Opinion (31/10/2009)

Based on the BSE website, the current EPS is Rs.786 and PE is 20.21. But what they calculate is trailing 4 quarter earnings and not the FY 2009 EPS. So, let us reduce our expectation of FY2009 EPS of Rs.850- Rs.900 to Rs.800 - Rs.850. US market is trading around the PE of 14-15 and so does other developed markets. If we assume the same PE, then multiplying the PE of 15 with our new assumed EPS of Rs.800 to Rs.850 gives you the SENSEX level of 12000 to 12750. But India being a fast developing country with a growth rate of around 6 percent for the time being (Growth Rates might increase to the levels of 8 if all the parameters combine well), Investors are ready to put a premium on our scrips and hence we need to take that into account. So, we need to add that premium and there is no hard and fast rule to do that and I just personally assume the PE of 3 - 4 for the “India Growth” Premium and adding another 2400 to 3200, the SENSEX would stand at 14400 to 15200 to make sense.

We can also cross check this number by another method. Corrections are called Corrections if they decline by 10 percent or less historically. It just depends on who is calling it. Some people call it corrections even if the decline is 20 percent. But we will take it as 10 percent. So 10 percent of 17000 is 1700 and if we deduct that from the SENSEX level of 17000 which we had just a week back, then the SENSEX would stand around 15300 and SENSEX level of around 15000 seems to make sense. I am not into any technical analysis or any predictions but just looking at these numbers tells me that the SENSEX level of 15000 makes sense for our markets for the time being and I thinks thats where market is heading to. Anything less than that would be an undervalued market and anything more than that would be an over valued market. If the outlook for the earnings increases, then we might be forced to revise our assumptions and markets might head up. But the overall long term uptrend is intact particularly in case of our Indian Markets and I have no doubt that all these corrections are just aberrations in long term growth story and also an opportunity for the investors to accumulate good stocks.

Some Recent Major Single Day falls in SENSEX

1. January 21, 2008 - 1408 Points
2. October 24, 2008 - 1070 Points
3. March 17, 2008 - 951 Points
4. July 6, 2009 – 870 Points
5. January 22, 2008 - 858 Points
6. February 11, 2008 – 833 Points
7. May 18, 2006 – 826 Points
8. October 10, 2008 – 800 Points
9. March 13, 2008 – 770 Points
10. December 17, 2007 – 769 Points

Am I expecting a fall like this in near future?? Hell no hopefully. But anything can happen in these markets.

Kumaran Seenivasan


Shabu's October 31, 2009 at 2:44 AM  

Dear Kumaran,

Fine exertion on the so discussed term "correction". As you said, market is heading towards it's actual or genuine place. Any way, such refinements are inevitable part of the story, but creats good opportunity for investors. Good work! Keep it up...

Thanks and regards

Faisal Humayun October 31, 2009 at 9:37 AM  

A nice post and a good analysis of the PE...In my opinion as well something around 15k might be the fair value for the markets...

As far as a crash is concerned, my opinion is that the markets should not have one of these big 600-1000 points crashes in the near term...The reason to feel that way is the amount of liquidity that is present in the system...

You will note that in all the major crashes you have talked about, the Dollar was very strong, TED Spread was high and thus the liquidity scenario was tight...

But for now there is too much of liquidity in the system...That why I feel that even fundamentals can go for a toss if all this money gets pumped in the markets...

But high level of speculation needs some mood...and that will take some time to come back...

Kumaran October 31, 2009 at 10:34 AM  

Shabu & Faisal,

Thanks for your encouraging comments guys!

Faisal, you are right that even I do not expect any big single day falls as people would be forced to buy at lower levels. But I am bit skeptic about the US markets which might trigger another crazy fall. Otherwise there is nothing that suggests a fall in domestic front.


Mahesh November 1, 2009 at 12:27 AM  


Crystal clear explanation..You above three guys are doing great job[shabu, faisal and u]..And i hope many ppl are benefiting from you..Keep up the work.

Thank you so much.

rbguru November 4, 2009 at 2:41 AM  

i agree...i stumbled upon your blog recently and find all articles lucidly explained. Though there is information everywhere, coming across organised knowledge that can straightway translate to action is difficult to come across. Keep blogging...

Krishna Raaj November 4, 2009 at 7:34 AM  


I am a great fan of your blog and learnt so many things from your articles.

The main reason for the recent correction is because of the carry on trade with the dollar and the hint given by the RBI in the recent policy that they might increase interest rates and tighten money supply. TO sum it up :Most of the hedge funds throughout the world are borrowing dollar money at zero percent and investing in risky assets like equity,commodities. So when the RBI gave a hint that they might increase the interest rates and tighten money supply they pulled back the money cause they can get better returns in other countries where they still have loose monetary policy.So you can see that the markets went down from the day RBI announced the policy until today cause finance minister told yesterday that India may also have lose monetary policy until the economy stabilizes. So I think we can have bull market until dollar stays weak , India does not increase rates , still keeps the loose monetary policy. Of course RBI can't afford to keep low interest rates and the economic stimulus continuing for a long times but we have to careful when they start doing that.

Ajay November 6, 2009 at 12:55 PM  


Can you please share anything on this?

Krishna,  November 7, 2009 at 12:23 AM  

Kumaran..very good article and it make things very clear on how P/E is calculated...Thank you for sharing your expertise...

Best Regards,

Nannu,  November 16, 2009 at 8:20 AM  

Dear Kumaran,

Excellent artical once again, Never miss a article from you. You have helped my understanding of the stock market in a big way. Thanks for your articles. I had read a article from Economics times named "Perils of Dollar Carry trade" dated 6th November wherein the author talked about how asset bubbles would get created due to carry trade. That has made me sligthly afraid to invest in stock market at these valuation. Please could you give your thoughts on current carry trade scenario in Indian stock market context.


Mohit Khanna December 25, 2009 at 12:48 AM  

Good Blog altogether......!! very deep insights abt mkts.... amazing


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