This Article was originally published in The Global Analyst
Equity markets are not for faint-hearted as they gyrate a lot due to several reasons. During the first two months of 2022, the Nifty opened at 17,625 and went on to reach a high of 18,308 on 17th January only to touch a low of 16,842 on 14th February and is currently placed at 17,112. Foreign investors have pulled out nearly $6 billion during the current year of 2022 while they pulled out $10 billion during the FY 2022. It is important to note, that during 2021 foreign investors poured a net of $38 billion in the market. Due to consistent investing over time, foreign investors now account for nearly 20% of Indian market capitalization. Hence, they no longer can be counted as “hot money” as they have good skin in the game.
Causes of volatility – No single reason
Stock markets experience volatility due to several reasons. Most of the time it reacts to economic happenings that will have an impact on companies (budget is a good example). Economic discourse normally surrounds broader metrics like GDP growth, fiscal deficit, current account deficit, inflation and interest rates. For e.g., the increasing oil price tends to increase inflation which in turn increases interest rates. This increases financing cost, and where companies cannot pass on this cost, their margins are squeezed. Hence, markets follow economic events very closely. It is said that $1 increase in oil price translates into a $1 billion increase in our import bill.
At other times, geopolitical reasons could infuse volatility (like Russia-Ukraine crisis now). These events normally influence investors to react either in a bullish manner (where most of them buy) or in a bearish manner (where they sell). Investors also comprise two varieties i.e, institutional and retail. Among the institutional category, the foreign investors count as most important as they wield more money power than others. Retail investors normally catch the action after the fact. The key factor to note is that volatility is a permanent thing for capital markets and hence markets experience a see-saw like patterns where some days it is positive while on other days it is negative.
The key question is how to react to market volatility. In order to get there, it may be instructive to see what a typical day in a market looks like vis-à-vis a non-typical day.
A look at data since year 2000 (approximately two decades) shows that nearly 65% of the time, daily returns for Nifty range between -1% to +1%. One should consider these days as normal or typical for the stock market. However, there are days when we notice a breakout from this trend, and market can either be extremely bullish or bearish. For eg., on 12% of the days have the market exhibited a return of +/- 2%. It is during such extreme movements, investors exhibit extreme tendencies. Smart investors look at them as opportunities to buy or sell while most of the investors just watch on the sidelines.
While reacting to market volatility, past lessons can be very instructive. Bear market episodes are captured through a metric called “drawdowns” which measures the fall in the index from a new high to low and back to high. This is also called “peak-trough-peak” study. Each fall from a peak to trough is termed as a drawdown. Here is a list of all key drawdowns for Nifty.
Some of the drawdowns can be mild and less painful like the one we saw in 2005. During this time, the Nifty index fell from a peak of 2,169 to a low of 1,903 and then recovered back to the peak with a full cycle of 104 days (roughly 3 months). The fall from peak to trough is 12.3%, not too steep to worry about. However, we also have drawdown episodes that can be very painful like the one in 2008 experienced during Global financial crisis. During this period, the Nifty index fell from a high of 6,288 to a low of 2,524 (implying a fall of nearly 60%!). It took nearly 2,246 days for the episode to come a full circle (nearly 6 years). In other words, if an investor invested at the peak, should have to wait 6 years before they can come to a no-profit no-loss situation. The drawdown experienced during the Corona event in 2020 was painful in terms of loss (-38%) but it played out swiftly from a time perspective (297 days).
Market Drawdowns are a regular phenomenon and hence they are very important to understand. Normally investors panic to a fall and rush to exit their positions, however this happens after a bit of a wait. Hence, they may end up selling at the trough (rather than the peak). The pain point experience is also at its maximum at the trough and only very strong-willed investors can just watch a fall of say 50% in their portfolio value and keep smiling or even better buying. As we have seen from the statistics, all drawdowns eventually claw back though at differing speeds. But eventually they claw back. If an investor chooses to do nothing (meaning not to panic sell), then he/she would simply have experienced a wild ride but with no financial consequence. However, the problem arises only when investors venture to action during drawdowns.
Every market drawdown will give a feeling that this is the end of the road. However, people that used these drawdowns as buying opportunities have never regretted going by the past experience.