How best to deal with volatile markets

After weeks of fluctuating stock prices on equity markets, two age-old questions that always accompany such market malaise have come to the fore:

• Why is the market going down?
• Is the correction over? Should I average? 

Put another way, investors are eager to learn whether it's safe to invest in the stock market again, or whether they should pull out of stocks. Market experts are equally eager to give them sage advice.

Will the market touch 9000? How about 8500? Technically can it come to 7886? Surely, 6000 sounds impossible, no? If I say, I have no clue. They then ask me the following 'fundamental questions'.

Is it all about interest rates? Or oil prices? Or global recession? Or US slowdown? So why are stock markets down the world over? I know that rising inflation expectations and higher interest rates in the United States (the Indian noises are equally bad - Bank chairmen and the finance minister have divergent views) have been held responsible, but rates have been rising for more than a year and a half now. Yes, that is the lag effect, did I hear?

In fact, the 10-year treasury bond rate has barely moved in the last few weeks, when the market downturn has been pronounced. The honest answer to this question is that we can point to no proximate reason that accounts for dropping stock prices.

Like all market declines in history, this one can be attributed to a collection of small news items destabilising markets that were close to the tipping point to begin with.

The government of India has absolutely no control on its expenses, has no ability to push through reforms, and divestments have been stymied. This will surely raise interest rates.

Is it time to buy again?

But is the correction over? That's an equally difficult question to answer, simply because there is no identifiable cause for the market drop. If there were, we could calibrate our responses, accordingly.

In other words, if stock markets are down globally because interest rates in the US are rising, they should stop going down when rates stop going up. (Snigger, snigger I have heard that one before).

That doesn't stop us from trying to second-guess markets, though. We are all market timers at heart, and we draw on the tools that researchers and analysts have concluded are useful in forecasting future market moves. Some of these tools can be categorised as technical indicators-chart patterns and volume measures. Some are fundamental and include value comparisons:

Comparing the earnings yield (the inverse of the P/E ratio) to the bond rate is one example. Proponents of these measures point to their unerring accuracy in predicting market movements, but here comes the bad news. Lets' see what the experts think. A big merchant banker thought Maruti was a good share to be listed at Rs. 125. At that point a writer in the leading general daily called it overpriced. Now, the price is 800 and growing.

A big merchant banker thought Deccan Airways was fairly priced at Rs 175. It subsequently was issued at a lower price. At Rs 70 observers are saying wait for prices to reach Rs 50.

The truth is pundits do not know, just as we do not know. Only sure thing is that the market over did the India growth story (I am saying this from hind sight) and now we will overdo the lack of liquidity theory.

Let's say the fair market value was 9k - we went all the way to 12k, now we will go to 7.5k on the way down. So get ready for the churn.

First, these indicators, be they technical or fundamental, have very high error rates. Even the best of them are wrong almost as often as they are right. Second, even those indicators that get market direction right almost never get the timing right.

We all believe we can time the market, and the 'expected pay off' is too tempting for us to let go of such opportunities. Its like the weather forecast computers have not helped. Only thing certain is if you do not take an umbrella today because it did not rain yesterday, it is a sure way of getting drenched.

Tips for a down market
So, what's a stock market investor's best response to dropping stock prices?

First, forget about rationalizing and explaining (or listening to other people explain) why stocks are falling. It's a pointless exercise at best, and misleading at worst.

Second, file the painful experience away as a worthwhile reminder of the riskiness of stocks, and draw on that memory during the next market boom when optimistic market seers tell you that stocks are really not risky (Remember Sensex 25,000).

If you believe, based on your preferred market measure, that stocks have overcorrected, don't wait for the correction to end. Investors who wait for final and complete confirmation that the market has turned around invariably miss the bulk of the turnaround.

I was investing in 1997 through 2006 - it had nothing to do with the equity markets. It was a conviction that long-term monies should be in equities. So, if I have long-term money, it goes into equity, other wise it goes into a money market mutual fund.

Recognise that even if you are right about the market overcompensating for past mistakes, there will be months of pain before the gain. Being a contrarian is easy on paper but much tougher in practice.

Markets will go up and go down - you cannot change that. You can change the way you look at it. When you have money you will invest, when you need money you will sell. There is no call to action based on 'what the market will do'. So that does not matter.

Finally, console yourself with the recognition that the professional portfolio managers and the market experts you see on television are staring into tele-prompters not crystal balls.

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