The market corrections during earlier bull runs were steeper

The market corrections during earlier bull runs were steeper

If we take the 11 February low of 17,295 points on the Sensex, the market fall has been 18.1% from its peak of 21,108 reached on 10 November. But while the fall has led to a lot of panic, market corrections during the last bull run have been much steeper. For instance, between January and May 2004, the Sensex fell from a high of 6,249 to a low of 4,227, a drop of 32.4%. That fall was part of a pull back in all emerging markets on concerns of monetary tightening in the US, although it was exacerbated in the Indian market by the formation of a government supported by the Left. With the benefit of hindsight, of course, it’s quite clear the reaction was overdone and, as subsequent events have proved, the government was quite capable of holding up reform on its own without any assistance from the Left.

Also read |Manas Chakravarty’s earlier columns

Also see | Inversely correlated (PDF)

The next big fall occurred between May 2006 when the Sensex reached a high of 12,671 and June 2006 when it reached a low of 8,799, a drop of 30.6%. Interestingly, the concern then was a resurgence of inflation and a series of monetary tightening measures by central banks across the world, including a surprise increase in the policy rate by the Reserve Bank of India (RBI). Growth in India was very strong at that time too—indeed, growth for the fourth quarter of 2005-06 was 10.3%. Oil prices too had started to rise—between March and June 2006, they moved up from $63 a barrel to $71 a barrel. International wheat prices, too, started to go up, with US wheat futures climbing to two-year highs in mid-May 2006. Fears about tighter global liquidity, higher interest rates and the unwinding of the carry trade led to heightened risk aversion, with emerging markets bearing the brunt of the fall.

But the mid-2006 correction turned out to be just a scare. The Sensex crossed the highs reached in May 2006 by October of that year. It closed the year 8.8% above the May high point.

Will the current correction, too, turn out to be a scare, or are there more fundamental reasons for the decline? Well, to start with, there are plenty of differences between 2006 and the present. Globally, the developed markets hadn’t had a financial crisis and much of the concern was with monetary tightening by central banks in the developed world. In 2006, all markets had been affected. This time, it is the emerging markets that have slipped while markets in the developed world have rallied.

But are there substantial differences between the Indian economy in 2006 and the economy at present? Wholesale price inflation was 5.5% in May 2006 and 4.3% in June, far below the current rate of inflation. In spite of much lower inflation, though, RBI increased its repo rate by 25 basis points to 6.75% in June 2006—that’s 25 basis points more than the current repo rate.

But interest rates on bank deposits of between one and three years maturity were 6-6.5% in 2005-06, much lower than at present. Banks’ credit-deposit ratio in mid-June 2006 was around 70%, well below the current 75% or so. Companies were increasing capital expenditure and the growth in gross fixed capital formation during the first quarter of 2006-07 was 16%, in spite of the turmoil in the markets. Contrast that with the very low growth in gross capital formation expected in the second half of the current year, according to the Central Statistical Organisation’s advance estimate for the gross domestic product (GDP). In short, there was still some juice left in the economy, which ultimately resulted in GDP growth of 9.7% in 2006-07.

What about the markets? In May 2006, the trailing price-earnings multiple of the Sensex companies was 20.4. In January 2011, it was 22. From that perspective, we should be very thankful if the current decline is limited to the lows touched recently.

Emerging markets are often inversely correlated to the level of interest rates in the US. In 2006, for instance, the yield on the 10-year US treasury went up from 4.42% in January to 4.99% in April and thereafter to an average of 5.11% in May and June, falling back thereafter. The chart shows the close inverse correlation between the US 10-year yield and the Sensex since the market recovery began in March 2009. In particular, notice the upward move in the US 10-year treasury yield since November 2010 and the fall in the Sensex since then. Tracking the US 10-year treasury yield may therefore be one indicator of where our markets are heading. Unfortunately, as the recent Bank of America-Merrill Lynch survey says, inflation expectations have soared to a six-year high. That could keep US bond yields high.

Manas Chakravarty looks at trends and issues in the financial markets. Comment at