Stock market correction: How to prepare for bad days during good times

On September 11, 2023, KIE published a report saying that: “There is no meaningful change in the fundamentals of most companies; in fact, they have worsened in many cases. The primary driver of the rally appears to be irrational exuberance among investors.”

On June 16, 2024, KIE made similar points all over again. In a tongue-in-cheek manner, it reiterated what it had said in September 2023: “The pond [that is the stock market] seems to have overheated of late, visible in the bubbles in the water.” However, many investors remained oblivious to these bubbles in the stock market, KIE said.

Now, here’s the interesting thing: As of September 8, 2023, the last trading day before September 11, 2023, the BSE MidSmallCap Index had closed at 8,744.2 points. On September 9, 2024, the BSE MidSmallCap Index closed at 12,618.7 points, or more than 44% higher than it was at around the same time last year. The price-to-earnings ratio of the stocks that make up for this index had stood at around 28 times in September last year. Currently, it stands at over 39 times.

What does this mean?

First, the prices of the stocks that make up this index have gone up at a much faster pace than the earnings of the companies these stocks represent. Second, the fact that earnings of the small and midcap stocks haven’t gone up at a pace to justify their 44% rise in average price, is something that the retail investors—who are primarily driving the current surge—aren’t really bothered about, because if they were the prices wouldn’t have gone up in the first place.

So, does this mean that KIE was wrong about what it said? Yes and no. It was totally right about the fact that prices of many stocks reek of irrational exuberance and that their earnings don’t justify their prices. Anyone who has stayed in the Indian market long enough and is trying to be honest about things would say so. But just because stock prices are irrationally exuberant doesn’t mean that the investors are likely to recognise that fact and quickly sell stocks and get done with it.

It’s one thing calling out a bubble, it’s totally another thing figuring out when the bubble will start running out of steam and eventually burst. Take the case of Alan Greenspan, the former chairperson of the Federal Reserve of the United States (US), the American central bank. In the 1990s, the US was in the midst of a dotcom bubble. Stocks of dotcom companies with no earnings and no prospects of future earnings were selling at very high prices. On December 5, 1996, Greenspan gave a speech, in which he mildly suggested that stock prices in the US might be irrationally exuberant. It was his own little attempt to prick the dotcom bubble. But nothing really happened. Things continued as it is for the next few years, until the bubble started to run out of steam in early 2000 and then burst during the course of the year and the next year.

Indeed, a year since September 2023 it is safe to say that something similar seems to have happened to KIE’s forecast of irrational exuberance and that they were unable to find too many stocks which offer a decent potential upside, which was a fancy way of saying that stock prices won’t go up much from where they were at that point of time.

But that hasn’t turned out to be the case. Why?

And that’s what seems to be happening in India currently. Many retail investors buoyed by the returns they have made through investing in stocks in recent years, essentially believe that these times can only continue. A bulk of these investors have entered the market only post-March 2020 and have next to no experience of markets falling on a sustained basis. It’s a black swan for them: something that has not been seen and thus cannot exist. Or to put it simply as I was told very confidently recently: Equity mutual funds are what fixed deposits used to be for our parents. The perception of risk has totally changed.

So, one can predict a bubble looking at the prices of shares, their current earnings and the prospect of future earnings, given that there is some science behind this. But one can’t predict the minds of millions of investors and what they are thinking at a given point of time, or as the economist John Maynard Keynes once put it, what the average opinion expects the average opinion to be.

In recent months talks of the stock market falling have started all over again. The reasons offered have been multiple: 1) The end of the yen carry trade as interest rates in Japan go up. 2) The prospects of an economic slowdown in the US. 3) The slowing earnings of Indian companies. And so on.

The trouble is that the slowing earnings argument could and was offered before, but that hasn’t impacted stock prices even a bit. Before the US economic slowdown argument was offered, it was said that stock prices will fall because interest rates in the US were being raised in order to control high inflation. It can also be argued now that the Federal Reserve in order to fight the prospects of an economic slowdown might start lowering interest rates in the US. And lower interest rates will ensure that more money will come into stocks.

So, the point is that no one really knows for sure.

• First, pay no attention to those in the business of predicting which way the market is going. (I also do that on some days.) It’s their job. They are incentivised to do so.
• Second, preparation for the bad days, if and when, and as and when they come, has to happen during the good days. You have to be prepared.
• Third, if you do not have at least 12 months of your income saved away in a savings account or a fixed deposit, as an emergency fund, this might be the right time to start building it by cashing in on some stock market gains.
• Fourth, of course, I can’t see the future, and the market can go up even further from here, but as I said preparation for the bad days can happen only during good days, and that also comes at a cost.
• Fifth, the fear of missing out (FOMO), and piling on more and more of your money into stocks, as valuations remain excessive and prices go higher, without adequate diversification, cannot and should not be an investment strategy. No one became wealthy that way. Of course, it’s good fun.
• Sixth, as always, diversification is the only game in investment town. Have your money spread across different asset classes (gold, fixed deposits, savings accounts, stocks and mutual funds). Even within an asset class, have your money spread around. I say this from experience. Taken in by the euphoria in the run up to the stock market bubble of 2007 and 2008, I had bet a lot of my money in equity mutual funds being managed by one fund manager. It turned out to be a terrible decision.
• Seventh, it’s worth recalling what Chuck Prince, the then CEO of Citigroup, told the Financial Times in July 2007: “When the music stops… things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing.” This mindset explains why institutional investors remain consistently optimistic. Publicly, they always project confidence that the markets will keep rising. They simply can’t afford to stop dancing.

But you, dear reader, do not have to fall for FOMO and keep dancing all the time. It might be a good time to take some money off the table and ensure that you are adequately diversified in line with the risk you are comfortable taking, simply because no one really knows when the market has reached its top level and will start falling from there. All that is obvious only in hindsight.