Triune Brain & Investor Psychology

In one of my previous blogs I had written that there are mainly 5 major factors which affect stock markets (or price of any thing which is determined by free market forces) and those are – economic factors, monetary factors, fundamental analysis, technical analysis and psychological factors. There has been lots of research, books and material available on the first 4 factors but the most important and I would say the deciding factor is the 5^th one i.e. psychological factors and very little has been written or appreciated on it. Whatever may be our method of investing, whether fundamental or technical or any other, do we actually do what we had initially decided to do. What if the price goes against our decision – do we still stick to our conviction? For example, an investor after doing full fundamental research on a stock whose current price is Rs.100 concludes that its value is Rs.150 and hence buys that stock. Now, for no fault of the stock and all the original fundamental factors being intact, the stock falls to say around Rs.75 because of the overall market fall or some humour surrounding the stock etc. Then what does the investor do – does he / she panic and exit the stock at a loss or rather because the original premise for which he / she bought the stock has not changed, simply hold on to the stock or infact buy more. That deals with “Investor Psychology”. Whether in stock market or any other walk of life, beating the market is not that difficult but rather beating our “own selves” is the real difficult part. Beating ourselves simply means mastering our own emotions and the ability to think rationally and independently in the face of all the noise surrounding us.

Psychology is a big subject and beyond the scope of this article but very broadly we have to understand our own selves (whether we are speculator, trader or investor, our strengths and weakness and then consolidate on our strengths and minimize the weaknesses). We have to not believe any expert or guru at face value (including myself although I don’t claim to be an expert but just a student of investing), we should have independent thinking, be patient and persistent, should know how to follow the trend and when to go contrary, how to profit from news breaks and media (rather than just getting carried away by the noise around us), should know how to deal with brokers and fund managers (remember its their “compulsion” to be always bullish or not bearish) etc. And remember that the biggest enemy of an investor is pride – the thought that he / she can never go wrong and not accept his / her mistakes (if I go wrong on any of my views then I put the confession in italics because even if the reader misses where I might have gone right, he / she should know where I have gone wrong). Market is the biggest deflator of our egos. The great Mr. Charles Dow (founder of Wall Street Journal and the all season “Dow Theory”) had once said that “pride of opinion has been responsible for the downfall of more men on wall street than any other factor”.

We may talk a lot about psychological behavior and how it is a very important factor in determining our success not only as an investor but also in other facets of life but do we really know how to develop our “brain psychology” so that it works for our benefit and not otherwise. I am not a doctor, scientist or psychologist by qualification but I do think that understanding human brain psychology is of utmost importance in the investment world as well as in any field – basically its most important for us humans to succeed as social animals. Now, what is human psychology, for that we have to understand our human brain and how it functions because finally we all our controlled by our brains (conscious and subconscious minds). Dr. Paul MacLean, a great neurologist and researcher, has brought the concept of “Triune Brain” or the three layered brain.      

The three major layers or 'brains' were established successively in human evolution. Each of the three brain layers represents a distinct evolutionary stratum that has formed upon the older layer before it like an archaeological city. The oldest layer is the reptilian (non-thinking) brain, the second oldest is the mammalian (emotional) brain and the most recent is the cerebral (thinking) brain. Each of the three brains is connected by nerves to the other two. Each brain operates as its own brain system with distinct capacities for perceiving and responding to the environment and each can become dominant depending on the circumstances. The major problem with human psychology and irrational behavior is that the integration and coordination between the three brains is inadequate, a genetic problem in our species. This has implications for human development.

Reptilian Brain or R-complex: The reptilian brain is the oldest layer - the most 'primitive' of the three brain components and makes up the entire brain mass in reptiles. The reptilian brain consists largely of the structures. Functions of the reptilian brain are related to physical survival and body maintenance - digestion, reproduction, circulation, breathing, stress responses, territorial instincts, social dominance, ritualism, social dominance, status maintenance, deception, tendency to follow precedent, awe for authority, social pecking order behavior, compulsiveness, deception, prejudice and resistance to change, rigid, obsessive, compulsive, paranoid etc. The functioning of the reptilian brain is activated when the organism perceives threat and the needs for survival and safety predominate. This part of the brain is active, even in deep sleep. Kindly note, this is the only part of the brain which is NOT in human control – lot of bad human behavior, wrong decisions and other psychological problems happen because of the reptilian brain and a not proper functioning mammalian brain (explained later on).

Mammalian Brain or limbic system: The second layer middle part of the brain occupies the lower fifth of the human brain and developed with the evolution of mammals. As a brain system, the mammalian brain consists of a series of brain structures around the brainstem which contains the Reptilian brain. The mammalian brain functions in primary seat of emotions of fear, joy, rage, pleasure and pain, attention, and affective (emotion-charged) memories, what gets your attention, unpredictability, feeding, fighting, fleeing, memory and sexual behavior.

Cerebral cortex or neo-cortex or rational thinking brain: The third layer which occupies five sixths of the brain is known the 'neocortex' or the 'cerebral cortex'. The cerebral brain is the latest evolutionary development of the brain.  The cerebral brain is involved with most mental activity, including spatial and mathematical thinking, meditating, dreaming, remembering, processing and decoding of sensory information.  The cerebral brain is divided into left and right hemispheres -left and right brain.  The left hemisphere is linear, rational, and verbal and controls the right side of the body. The right hemisphere is spatial, abstract, musical and artistic and controls the left side of the body. For example, generally speaking, highly educated people like doctors, lawyers, engineers, Chartered Accountants etc have highly developed “left cerebral brain” while persons involving in creating professions like actors, singers, painters, musicians etc have more developed “right cerebral brain”.

The interaction of the three brain layers forms the biological basis for the interaction of concepts, emotions and behaviors which make up the learning process. The reader might think that the cerebral brain dominates the mammalian and the reptilian brains. However, you will be surprised to read that the cerebral brain generally is the weakest of the three and that the mental functions of the cerebral (thinking) brain can be hijacked by the functions of the other two brain layers. This is the main reason while totally rational individuals take totally irrational decisions under specific situations of life (including investments). For example, the reptilian (non thinking) brain runs automatically and not in our control (because it controls vital survival functions like breathing, digestion, circulation, reproduction etc) and it is that part of the brain which immediately starts functioning even without our knowledge. Suppose, somebody gave you a complex mathematical problem, you will not have a direct answer, you will have to activate your cerebral (thinking) brain to solve the equation. On the other hand, the reptilian brain immediately gets activated even before we realize – suppose you just see picture of a McDonald burger, your mouth might immediately water although your cerebral (thinking) brain knows that there is no burger but the reptilian brain had stored the real burger picture in its memory which you might have eaten in the past and associates the photo picture with it. Hence, although we may be rational human beings and like to use our cerebral (thinking) brain but most of the times are fooled by the automatic images of the reptilian brain which “fools” the mammalian (emotional) brain to re-direct the power to it instead of the cerebral “thinking” brain.

Now, we will consider this in light of a stock market example. Let us take the example of the past 4-years stock market which might be still fresh in investor’s minds. We all know that to make money in stocks (or for that matter anything) we have to buy it cheaply and sell it costly. This rule we apply to almost all items as we go on extended shopping during times of “discount sales” and avoid buying when the items are unnecessary costly. However, why we are not able to apply this simple logic to stocks. Just consider, many of us might had invested when the Sensex was around 21000 in December 2007 when infact we should have sold. Then 1-year down the line, many of us “frustrated” investors might have sold at 8000 Sensex when infact we should have bought it. The same investors might have again purchased at close to 20000 Sensex in October 2010 which they had sold at 9000 Sensex in December 2008. And now in November 2011 those same “frustrated” investors might be contemplating of exiting those loss making investments at 15000 Sensex. Now, why do we rational investors behave in such an irrational manner. This is related to the three different brain systems explained above and their interaction and dominance of one above the other. Now, let us see what is actually going on through the investor’s mind at each of the different stages. Kindly note, the cerebral (thinking) brain is the weakest and unless consciously activated and used succumbs to the power of the other two brains. At 21000 Sensex in December 2007, the reptilian brain automatically tells the other two brains that the market has been going up and it shows the picture of the market going up (all pictures are stored and automatically retrieved in the reptilian brain). Next in line is mammalian (emotional) brain which receives the “signal and picture” from the reptilian brain that the market has gone up. The mammalian brain is emotional and there are feelings of joy of earning money in the stock market or fear of loosing money / not earning money. Now, at this point of time the cerebral (thinking) brain might be saying that logically the stocks are costly based on whatever evaluation like fundamentals, technicals etc but its voice is very weak amongst the three brains at this point of time. In essence the mammalian or emotional brain is the most powerful of the three because it now has the power to re-direct the situation back to either the reptilian (non-thinking) brain or the cerebral (thinking) brain. In most of us humans, the joy of thought of earning more money which the reptilian brain has induced on the mammalian (emotional) brain is much stronger than the real correct picture which the cerebral (thinking) brain is portraying. Hence, is majority of us the mammalian brain re-directs the power to the reptilian brain and that explains the behavior that although logically we know that at 21000 Sensex we should be selling and not buying but we still actually in action buy and not sell. This kind of behavior is associated with most of the actions which we human beings do in our day-to-day life under the influence of our reptilian (non-thinking) and mammalian (emotional) brain and ignoring our cerebral (thinking) brain in the process to our own peril.

Now, let me give another example related to the triune brain and a big social menace – sexual abuse and rape. When a male / female observes an attractive handsome / beautiful person of the opposite sex – the person unconsciously may get some kind of immediate sexual arousal. This is because the reptilian brain which stores the images and pictures and not in our active control immediately flash backs some kind of image picture of any person of the opposite sex which the person under question might have seen etc in the past and then he / she relates that picture to the person whom he/ she is currently viewing which in turn leads to some kind of excitement / arousal / interest in the person and upto here is natural, unconscious and uncontrollable. From now onwards what happens within the 3 brains is most important. The picture from the reptilian brain then goes to the mammalian brain which is the emotional brain which then attaches the joy of what it had or can experience with the person of the opposite sex in the past and at the same time it also experiences the fear of doing something wrong etc. The cerebral (thinking) brain is all the while saying that it should just keep quite and not proceed any further because it is wrong – however the cerebral brain is the weakest of the three unless the other two brains have relinquished their power in its favour. Now, in the majority of us, the mammalian (emotional) brain will not heed to the reptilian brain and give the power to the cerebral (thinking) brain and hence the person will sit quietly. However, in few persons, the mammalian brain will give the power to the reptilian brain which in turn will lead the person to do some wrong act like rape although his cerebral brain had been all the while stating that it is wrong. Further, in a normal person the thinking is in a wide perspective but when he / she gets sexually aroused then due to the release of certain “natural drugs” like dopamine, norepinephrine, testosterone, oxytocin and serotonin the thinking becomes narrowly focused only on the sexual arousal to the exclusion of other thoughts like social values, Government laws, family, work etc.

So, whether in investments or any other phase of our life, the problem happens with over-active reptilian brain and a weak mammalian brain. Hence, the key to succeed in investments or for that matter anything in our life is to slowdown our reptilian (non-thinking) brain, have a very strong mammalian (emotional) brain so that it can re-direct the power to our cerebral (thinking) brain.

Safe Investing and Happy honest Living!

Bond Mathematics for Fixed Income Securities

Although the name is Fixed Income securities, there are different types of risks while investing in fixed income securities. The major type of risks associated with fixed income securities are credit risks, interest rate risks, yield curve risks, liquidity risks and basis risks.

The most common risks which an investor attaches to fixed income investments is credit risk. Having said that, there is one more risk which is as important as credit risk i.e. interest rate risk. Few people understand this risk. For example, a long term Government of India Security (GSec) may have zero credit risk (because the Government can literally “print notes” and pay back the loan), but it has one of the highest interest rate risks. Interest rate risk is directly related with the maturity of a security. I will cover two very important contributors of interest rate risks in this note – duration and convexity.

Duration

I have seen many investors confuse duration with maturity. However, they both are distinctly different. Maturity is simply when the fixed income security will mature and pay back the principal. For example, the maturity of a 10-year paper will be 10 years at the time of issue. On the other hand, duration is the time within which the investor receives back all the cash flows related to the security i.e. interest and principal. For example, if there is a 10-year maturity paper paying yearly coupon at the interest rate of 8.0% p.a. issued at par (Rs.100) will have the following cash flows, 8 + 8 + 8 + 8 + 8 + 8 + 8 + 8 + 8 + 108 which will be paid at the end of every year for the next 10 years till it matures.  The Rs.8 is the interest at 8.0% p.a. on Rs.100 par value. Kindly note that at the end of the 10^th year the investor will receive Rs.108 i.e. Rs.100 of principal + Rs.8 of the 10^th year’s interest. This example clearly shows that although the maturity of the security is after 10-years, the investor receives cash flows frequently at regular intervals much before the final maturity of the security. That brings me to the concept of duration. The duration of a bond is defined as the “weighted average term to maturity of a security’s cash flows”. Since the cash flows on a security are received piecemeal before the actual maturity of the security, the duration of all coupon paying bonds will be less than its maturity. And as a Zero coupon bond does not pay any interest during its life, its duration = maturity.

There are different forms of duration. The basic one is the Macaulay or unadjusted duration. The one which we use for our calculation is the adjusted or Modified Duration. I would not go into the mathematical formulae of computing these but will explain the concepts which are necessary for understanding interest rate risks associated with fixed income securities.

Duration is useful primarily as a measure of the sensitivity of a bond's market price to interest rate (i.e. yield) movements. It is approximately equal to the percentage change in price for a given change in yield. For example, for small interest rate changes, the duration is the approximate percentage by which the value of the bond will fall for a 1% per annum increase in market interest rate. So a 10-year bond with a duration of 7 years would fall approximately 7% in value if the interest rate increased by 1% per annum. In other words, duration is the elasticity of the bond's price with respect to interest rates.

The summary of Duration characteristics is as follows:

Ø       The duration of a zero coupon bond will equal to its term to maturity.

Ø       The duration of a coupon paying bond will always be less than its term to maturity.

Ø       There is an inverse relationship between coupon and duration. The higher the coupon of a bond the lesser its duration and vice versa. The logic is simple because the higher the coupon, the sooner will the cash flows accrue to the investor and hence the lesser the interest rate risk associated with future cash flows.

Ø       There is generally a positive relationship between duration and term to maturity. Note that the duration of a coupon bond increases at a decreasing rate with maturity and the shape of the duration / maturity curve will depend on the coupon and the yield-to-maturity (YTM) of the bond.

Ø       There is an inverse relationship between YTM and duration.

Ø       Sinking fund and call provisions can cause dramatic change in the duration of a bond.

Convexity

Duration is a linear measure of how the price of a bond changes in response to interest rate changes. As interest rates change, the price does not change linearly, but rather is a convex function of interest rates. Convexity is a measure of the curvature of how the price of a bond changes as the interest rate changes. Convexity deals with the curvature of the price / yield relationship or chart. Specifically, duration can be formulated as the first derivative of the price function of the bond with respect to the interest rate in question, and the convexity as the second derivative.

Convexity also gives an idea of the spread of future cashflows. Just as the duration gives the discounted mean term, so convexity can be used to calculate the discounted standard deviation, say, of return.

Note that duration can be either negative or positive depending on the way the interest rates move but Convexity is always a positive feature of the bond. The exception to this rule is in the case of “callable bonds” where the convexity is a negative feature. By positive feature of convexity I mean that for a given change in interest rates and the modified duration of a bond, the change is price of the bond will be in favour of the investor. For example, because of the positive feature of convexity, when interest rates rise, the price of the bond will fall less than that indicated by the duration and when interest rates fall, the price of the bond will rise more than that indicated by the duration. This is because when we study the price / yield relationship of a coupon paying option free bond, the larger the increase in the YTM, the greater the magnitude of the error by which the modified duration will overestimate the bond’s price decline; the larger the decrease in the YTM, the greater the magnitude of the error by which the modified duration will underestimate the bond’s price rise.

As the YTM changes, the bond’s duration changes as well. Thus, modified duration is an accurate predictor of price change only for vanishing small changes in YTM.

Summary

Without making this note too long and complicated, the change in price of a fixed income security is duration times the change in yield i.e. for a security having a modified duration of 7 years, for every 1 % (100 bps) decrease in yield (interest rates), the price will go up by 1 * 7 = 7% and vice versa. Due to convexity of the bond, the gain will be little more than 7% in case of interest rate decline and the loss will be little less than 7% in case of interest rate increase.

Lessons from History

Abstract

The current turbulent and volatility witnessed in all the asset classes including equities, bonds, oil gold, base metals, real estate etc and the synchronized global bear market which we observed in the year 2008 are leaving many investors totally agashed. There has been lots of panic and every investor, analyst, fund manager are debating whether this is a bull market correction or a bear market and if the answer is the latter, than whether a structural or a cyclical one. This article tries to answer those questions by studying the US and Indian stock market history, price movements, valuations, interest rates etc.

Introduction

General Comments and Market levels

Economies and markets go through different cycles. As per Dow Theory (which according to me is the father of all technical Analysis and the most simple and logical), there are three movements of any markets which are publicly and liquidly traded. The first and most important is the primary trend – the broad upward or downward movement known as bull or bear markets which generally is of several years duration. The second and the most deceptive movement is the secondary reaction – an important decline in a primary bull market or a rally in a primary bear market. These reactions normally last for three weeks to three months. The third, and usually the unimportant, movement, is the daily fluctuations. I generally see the markets within the confines of these three movements. Once, we know the primary movement, whether bull or bear, we have to try to buy (sell) during the “secondary reactions” so as to try to get the maximum return once the primary bull (bear) market resumes. I am clear in my mind that currently we are very much in the midst of a “primary bull” market which began in March 2009 (and not October 2008) at the level of around 8050 (2520) on the Sensex (Nifty). Now, if we believe that this is a “primary bull market” then currently we are undergoing a “secondary correction” of the primary bull market and hence we have to aim to buy close to the end of the “secondary correction”. We have to remember that it is relatively easy to predict the primary trend, but very difficult to understand the secondary reactions because they are very quick, fast and do so much price damage that most investors believe that the primary bull market has ended and maybe bear market has begun. And just when everyone starts believing that, suddenly the primary bull market resumes which then takes the indices to new highs, above the previous “intermediate top” from where the “secondary reaction” had begun. Hence, secondary reactions are deceptive and they scare away most of the investors. These temporary reversal of market trends or secondary reactions are recognized as serving the same purpose marketwise as brakes do for a car – they act as a means of checking excess velocity. These secondary corrections generally correct 33% to 66% of the previous primary move with intermediate support levels. Hence, this market can correct to even 14700 and still it will be classified as a “secondary correction”. If the market goes below 14700 then the “primary trend” hypothesis will be challenged and in that case it would mean that this was not a “secondary correction” but the actual reversal in “primary trend”. There are intermediate support levels at 17800, 17300, 15900 and finally at 14700 (corresponding levels for Nifty it would be 5250, 5180, 4880, 4400). At each of these levels we have to be alert for bottom formation patterns and if that is confirmed we should be buying at those levels because it would mean the secondary reaction is running out of fuel and the primary bull market trend has resumed. If somebody still has doubt on these market movements, see the period between the years 2003 to 2008 when the Sensex went up from around 3000 to 21200, wherein there were atleast four corrections – June 2004 (Political – Congress comes to power with the help of Left parties), October 2005 (minor scam in penny stocks), April 2006 (mid cap stocks correction – had run up too fast) and August 2007 (global – first scare of the sub prime crisis) which were between 15% to 30% in price.

Lessons from History

Now, let us understand this with the basis on simple fundamental analysis. Exhibit I shows primary and secondary movement of the previous bull market. Although, the Sensex surged 7 times during the period of 2003 to 2008, there were four secondary corrections which took away 15% to 30% from the “intermediate tops” in matter of few weeks, shaking the conviction of even the strongest bull – that is the objective of secondary corrections- otherwise if money making in the market was so easy than nobody needed to do any other work! Also note, the subsequent movements, once the secondary correction is over and primary bull trend resumes is between 54% to 108%, much more than the secondary correction range of 15% to 30% - that’s because it was a primary bull market (the scenario will be opposite in a primary bear market). Now, fundamentally let us understand that generally bear market bottoms come closer to a P/E ratio of 10 (April 2003 or even March 2009) while bull market tops can happen anywhere between 25 to 40x P/E ratios. The important point here is that generally secondary corrections end at P/E of around 12 to 16x. The current Sensex P/E is around 17x and hence it certainly has further scope to go down. One more observation, that the market has undergone a secondary correction at 6035 which was around the same levels of 6175 touched in February 2000 which was the previous bull market top – before the technology bubble burst. The same thing has happened currently that the Sensex touched 21108 in January 2011 which was within striking distance of the previous bull market top of 21206 conquered in January 2008.

Exhibit I: Sensex levels & P/E along with secondary corrections

Date	Sensex	P / E	% Increase / Decline	Comments
Apr-03	2900	10.7		Bear market Bottom
Apr-04	6035	17.3	108.1%	Intermediate Top
May-04	4260	12.2	-29.4%	End of Secondary Correction
Sep-05	8750	19.4	105.4%	Intermediate Top
Oct-05	7600	16.9	-13.1%	End of Secondary Correction
Apr-06	12670	24.2	66.7%	Intermediate Top
May-06	8790	16.8	-30.6%	End of Secondary Correction
Jul-07	15900	22.1	80.9%	Intermediate Top
Aug-07	13800	19.2	-13.2%	End of Secondary Correction
Jan-08	21206	25.5	53.7%	Bull Market Top

Source: BSE

 Exhibit II : BSE Sensex levels & P/E along with secondary corrections

 

Exhibit II is an interesting chart which shows the various Sensex levels along with its P/E ratio. Bear market bottoms are generally around 10x P/E while bull market tops are anywhere between 25x to 40x. It is easy to predict bear market bottoms because at certain price stocks become very cheap on replacement cost and dividend yield basis and much more difficult to predict bull market tops because although however tall a tree may grow it can never touch the sky but when its going tall and fast nobody knows when it will stop growing and the same goes for bull markets also.

Exhibit III brings out the 150 years history of US S&P 500 P/E along with its long term interest rates. The great bear market bottoms of the past century in the US have been 1907, 1921, 1932, 1949, 1974 and 1982. Kindly note how the US markets have formed major bull market tops between 25 to 40x P/E ratios while the bear market bottoms have been closer to 8 to 10 P/E. Also note, how the initial bear markets of the last century in the US was in conjunction with deflation and hence low long term real interest rates while in the latter half was along with high inflation and the high interest rates – note the 1981 high long term interest rates of around 16% when the 50-year multi decade bear market in bonds ended and subsequently one of the longest bull markets in equities in US commenced. 

Exhibit III:  150 years of US S&P 500 P/E and Long Term Interest Rates

Source: econ.yale.shiller

Exhibit IV shows the past 115 years of US DJIA history of when it made bull market and intermediate tops and bear market bottoms (For complete US DJIA detailed history of major tops and bottoms kindly look at Exhibit VII at the end of this report). The major purpose of this table is to show how many years it takes for the market to conquer the previous bull market high and what kind of returns is generates for the investors. Kindly note, that it takes anywhere between 5 to 22 years for the market to go from one peak to another peak. Hence, the cycle of a primary bull market top to a bear market bottom to again conquering the previous primary bull market top takes around 5 to 22 years. Further, if somebody invests just when the previous bull market top has been tested i.e. for example at 21000 on Sensex in India in January 2011 then it generates CAGR returns of anywhere between -3.4% to 17.8% over the subsequent 5-year period. (average of 9.2%). Even somebody might believe that investing at bear market bottom would give excellent returns which is also far from truth because investing at bear market bottom and waiting till the previous bull market top arrives have yielded around 4.4% to 12.6% (average of just 6.0%). Hence, the major portion of the returns have not come by investing at bear market bottoms or when the market makes new highs above previous bull market tops but infact investing during the secondary correction which happens when after making a new high (or touching / approaching it i.e. the current period in India) or during the later / last leg of the bull market. 

Exhibit IV:  150 years of US S&P 500 P/E and Long Term Interest Rates

Date	US DJIA	P / E	Comments	CAGR Return from Bottom till it makes New High	Subsequent 5-year Return once crosses above previous high
Jan-06	103	19.9	Bull Market Top
Dec-07	58	10.6	Bear Market Bottom
Aug-19	107	12.8	Above previous high 162 months	4.4%	-3.4%
Jun-21	64	4.9	Bear Market Bottom
Nov-24	110	3.8	Above previous high 63 months	10.8%	19.8%
Sep-29	381	32.9	Bull Market Top
Nov-32	41	5.8	Bear Market Bottom
Nov-54	385	12.8	Above previous high 264 months	10.6%	7.4%
Dec-68	1050	22.3	Intermediate Top
Jul-74	600	8.9	Bear Market Bottom
Feb-83	1080	9.6	Above previous high 182 months	3.9%	13.1%
Jul-00	11500	44.2	Bull Market Top
Oct-06	11600	26.1	Above previous high 75 months	0.1%
Jan-08	14200	24.1	Intermediate Top - All Time High
			Average Return	6.0%	9.2%

Source: Dow Jones

Now, let us study this in light of our own BSE Sensex (Exhibit V). The Sensex made a “bull market top” at 4580 (P/E 61x) in April 1992 (Harshad Mehta scam). The subsequent bear market ensured 57.3% erosion in value to 1956 (P/E 24.1x) by April 1993 at the bear market bottom. However, that does not mean that the new bull market started – it only meant the end of the bear market. However, markets do rally, as have we seen in the last 120 years of US equity market history or the Indian markets from bear market bottoms. The same way, the Sensex rallied by 135% from a bear market low of 1956 in April 1993 to an “intermediate top” of 4600 (P/E 35.6x) in February 1994. However, the Sensex then went into hibernation for many years to come and made a new high only in December 1999 (P/E 18.1x) giving meager CAGR returns of 1.3% over a 7 ½ year period. It then went to the bull market top of 6120 (P/E 21.9) by February 2000 before the technology bubble bust. This high of 6120 in February 2000 gave a paltry CAGR return of just 4580 since the previous bull market top of April 1992. Also note, the subsequent 5-year CAGR return since the bull market top of 6120 in April 2000 was a measly 2% although the great bull market of 2003-2008 was very much underway. However, if we see the returns from the bottom of “secondary correction” of May 2004 to the “bull market top” of January 2008, then that comes to 400% absolute or importantly CAGR return of 54.4%. To conclude, the major money in market is not made by investing at “bull market tops” or even at “bear market bottoms” (unless somebody sells after the initial rally from the bear market bottom to the intermediate top – in the current context from 8040 in March 2009 to 21100 in January 2011), but the major “sustainable long term” return comes from investing in the subsequent secondary correction after the intermediate top has been made to the next bull market top. The rally from the “bear market bottom” (April 2009 – 8050) to the “intermediate top (January 2011 – 21100) is over and the initial more than 100% return has come and gone (as was the case in US during the years 1907, 1921, 1932, 1949, 1974, 1982 or in India in the years 1993 or recently 2009). Hence, in the present context, the major money is most likely now to be made by investing close to the current secondary market bottom (say between 15000 to 16000) to the next bull market top (between 30000 to 50000).  

Exhibit V:  India 20 years of Sensex history of Bull Market Tops and Bottoms

Source: BSE

Interest Rates & Equity markets

Currently, there is lot of fear amongst investors regarding the high inflation (particularly food and primary articles) and the resultant strict monetary policy, tight liquidity and high interest rates. The yield curve which was very steep with the 1-10 year spread of around 500 bps has today become inverted with the same 1-10 year spread at -100 bps. Today, banks are borrowing at around 10% bulk deposit rates, add 200 bps of operating expenses and around 300 bps of spread and their average lending rates to corproates would have to be around 15%. Now, lot of the top corproates must be easily borrowing at almost 300 to 500 bps below this “average rate” and hence the rate for the SME, unsecured retail and auto loans has to be close to 18% to 20%. I don’t think any business or consumer can survive at these high interest rates. Hence, the current high interest rates is the biggest cause of concern for equities – reduced bottomline through increase in finance and interest cost, reduced stock valuations to increase in discount rate and compete for the same investible surplus of the investor. Hence, for any meaningful recovery in equities it is a sine quo non that the interest rates have to first stabilize and then soften. Currently, India is going through a mini economic cycle. Now, let us concentrate on interest rates and compare it with equity valuations and markets. The best “composite valuation” for the stock and bond markets comes from comparison of the Earnings Yield (opposite of P/E) of the Sensex with the Bond yields (10-year GSec Yield). Exhibit VI shows the BSE Sensex along with the Earnings Yield / Bond Yield. Kindly note, how at higher Earnings Yield / Bond Yield the equity market bottom out while and lower Earnings Yield / Bond Yield they become very vulnerable. Currently, Earnings Yield / Bond Yield is around 0.7x as compared to the long term 15-year average of 0.9x. Hence, a reasonable correction in equity markets and corollary to that, softening of interest rates, is expected and will be played out over the next few weeks / months to correct this ratio. 

Exhibit VI:  BSE Sensex compared to Earnings Yield / Bond Yield

Source: BSE

Now, interest rates in India have reached close to those levels where it was at the depth of the financial and credit crisis in the year 2008. However, before we get scared with the current high interest rate and the hype around it, let us understand the economic or business cycle to drive home this point:

Ø       Interest rates peak and Bond prices bottom (Idle Asset Class - GSecs)

Ø       Demand for credit declines (Idle Asset Class - GSecs)

Ø       Central Bank comes into action (Idle Asset Class - GSecs & Corporate Bonds)

Ø       Equities Bottom Out (Idle Asset Class - Equities)

Ø       Commodities bottom out (Idle Asset Class Cyclical and Commodity Stocks / Commodities)

To sum up, its wise as an investor to position in the right asset class so as to make the maximum of the economic cycle – remember when one asset class is in a bear market most probably there is some other asset class which is in a bull market.

Conclusion & Outlook

Ø       Major money in the market is not made by investing at “bull market tops” or even at “bear market bottoms” but the major return comes from investing in the subsequent “secondary correction” after the “intermediate top” has been made to the next bull market top. (In the current context, would come close to the end of the current secondary correction which may be right away between 16500 to 18000 on Sensex).

Ø       Its always wise to look at composite valuation (Earnings Yield / Bond Yield) of equities compared with interest rates since there is no other single variable which affects equity prices as much as interest rates do.

Ø       The current “secondary equity correction” in India and other emerging markets like China is similar to that as in the US during 1982 (high commodity inflation when the economy is growing fast) as compared to the years 1921, 1932, 1949 which were led by deflation and falling prices.

Ø       Its wise as an investor to position in the right asset class so as to make the maximum of the economic cycle – remember when one asset class is in a bear market most probably there is some other asset class which is in a bull market.

Appendix

Exhibit VII: Major Market Levels of US DJIA since inception – 115 year history and future

Year		DJIA		Q Ratio*			Returns	Comments
1896		41						Inception
1905		98					139%	Multi Year High
1907		48					-51%	Bear Market Bottom
1919		110					129%	Bull Market Top
1921		64		0.28			-42%	Great Bear Market Bottom
1929		381					495%	Bull Market Top
1932		41		0.30			-89%	Great Bear Market Bottom
1937		190					363%	Bull Market Top
1938			92			-52%			Multi Year Low
1942			87			-5%			Multi Year Low
1946			211			143%			Multi Year High
1949			150		0.35	-29%			Great Bear Market Bottom
1968			1050			600%			Bull Market Top
1974			600		0.35	-43%			Bear Market Bottom
1981			1000			67%			Multi Year High
1982			769		0.27	-23%			Great Bear Market Bottom
2000			11500			1395%			Bull Market Top
2007			14198			10%			Multi Year High
	2009 to 2012		6000 to 8000						Great Bear Market Bottom
	Source: Dow Jones & Co.		*Ratio of the Price to the Replacement Value of Assets