What if we're in a bear market?

That's a rhetorical question because, going by the common definition, Indian stocks are already in a bear market. The Sensex has nose-dived 24 per cent from its perch of 21,000 in November 2010 to its low in early October. The unofficial definition of a bear market only requires stocks to drop by at least 20 per cent over two months or more. The action outside Sensex stocks indicates that 30 per cent of the NSE-listed stocks have plummeted more than 50 per cent. So, having recognised that we are indeed in a bear market, how should investors navigate it? We studied previous bear markets in India to arrive at the following suggestions on what investors can (and cannot) do.

Trying to make quick gains off a bear market by shorting stocks or the index is a risky strategy (see below). Whether an investor should buy stocks now would depend on the shape of his current portfolio and his investment horizon.

An opportunity to buy

What is a bear market but an opportunity to buy stocks cheap, if you are a long-term investor? The reason why many retail investors turn to equity markets, is not to punt on stocks, but to fund their children's education or their own retirement. If that goal is more than five years away, this is the time to take the plunge into equity markets.

Four factors suggest this is a good time to buy stocks. One, India Inc's current problems, whether with rising commodity prices, soaring interest rates or the stalling capex cycle, are of a cyclical nature. They have dented profits in recent quarters but are not expected to persist for more than a year or two. Commodity prices may cool off with the global slowdown. That may be prompt RBI to pause in hiking rates. The policy paralysis may let up once elections loom ahead.

Two, the PE multiple of the broader market (reflected in the CNX 500 stocks) has corrected from 24 times to 16.8 times in the last one year, making stocks much more attractive than a year ago. The current PE is also notches below the average PE enjoyed by Indian stocks in the last five years (18.5 times).

Three, if there is to be a rebound in the Indian economy's growth rates and with it corporate profits, stock prices are likely to move up ahead of the event. Even the 2009 bull market was driven more by a re-rating of PE multiples (expectation of better profits) than by actual earnings expansion. Between March 2009 and March 2011, the declared profits of Sensex companies expanded only by 48 per cent, but their combined stock market value vaulted by 112 per cent.

Where's the bottom?

Finally, bear phases in India (from peak to trough) have never lasted for more than two years. If you count the time taken from top to the bottom, the market crashes of 1992 and 1994 lasted 16 months each. The infamous dotcom crash of 2000 kept markets under pressure for 19 months at a stretch. In 2008-09, markets reversed direction in 13 months. Given that this particular bear market has stretched on for 11 months, the bottom may not be too far away. However, investors must take note that while the new few months may be a good time to buy, the returns will not materialise quickly as stocks will take time to reclaim their peaks ( See table ).

All the above factors however, do not preclude markets from sliding further over the next few months. The profit picture may well get worse before it improves. Persisting global worries can trigger FII pullouts and cause stock prices to fall much more than warranted by fundamentals. If the markets were to correct further from current levels, investors who put in money now will have to take short-term losses on their portfolio. While the markets may bottom out within the next few months, investors who have been buying into stocks through this fall will need to hold on longer to reap a reasonable return.

This is why it is a bad idea for investors with a holding period of less than three years to take big bets on equities at this juncture.

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