Friday, 11 November 2011

Lessons from History


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.


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

P / E
% Increase / Decline

Bear market Bottom
Intermediate Top
End of Secondary Correction
Intermediate Top
End of Secondary Correction
Intermediate Top
End of Secondary Correction
Intermediate Top
End of Secondary Correction
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

P / E
CAGR Return from Bottom till it makes New High
Subsequent 5-year Return once crosses above previous high
Bull Market Top

Bear Market Bottom

Above previous high 162 months
Bear Market Bottom

Above previous high 63 months
Bull Market Top

Bear Market Bottom

Above previous high 264 months
Intermediate Top

Bear Market Bottom

Above previous high 182 months
Bull Market Top

Above previous high 75 months

Intermediate Top - All Time High

Average Return

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.


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

Q Ratio*




Multi Year High


Bear Market Bottom


Bull Market Top

Great Bear Market Bottom


Bull Market Top

Great Bear Market Bottom


Bull Market Top


Multi Year Low

Multi Year Low

Multi Year High
Great Bear Market Bottom

Bull Market Top
Bear Market Bottom

Multi Year High
Great Bear Market Bottom

Bull Market Top

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


  1. Hi Mehrab,

    Thanks for your thoughts. While I understand that you follow the Dow T, don't you think the present market is following the classic case of lower tops and lower bottoms ? And hence a strong case for being classified as a bear market ?

    Pls let know your thoughts.


  2. It was a great piece of information. First I used to see the market from 3 to 9 months perspective..then later from 1 to 3 years..but now after reading your article this going to change and lot of my predictions are going to change. I had predicted for Nifty bottom at 4500(max)in 2011..150 points away from recent low of 4650. I also read your article on Gold..but don't you think that gold will first correct upto 1300/oz or 1025/oz(worst case) before resuming the uptrend.. also DJIA has not corrected much since its multi year high. Infact for year 2011 it has given marginal positive returns ..can uyou please give your view on the same