Everything you need to know about Stock Market Correction and Precaution

The basic reason why the market correction occurs is that the price the market is paying currently or has paid for the stocks is/will not matching/match the returns you are/will getting/get in future.

Stock market correction is what you are witnessing and experiencing (painfully) today. Markets, to be true, are basically trading marketplaces and hence irrational.

If you think that the price rise is going to stop at a point that you think is logical, you are mistaken. The price of a script will continue to rise until supply exceeds demand. The "supply vs demand" will act as a natural break to the uninterrupted price upwards movement.

Why does market correction occur?

The basic reason why the market correction occurs is that the price the market is paying currently or has paid for the stocks is/will not matching/match the returns you are/will getting/get in future.

stock market correction history, frequency of market correction, Stock Market Correction, Market Correction, market crash, stock market correction India,
Image credit - CNN Money

Traders quickly jump in the fray once they spot a script that will provide manifold returns in future. But they are equally adept to dump the script if they catch a whiff of earnings downgrade possibility of the same stock. A probable sector earnings downgrade pulls down the whole lot of shares comprising that sector.

To understand why the capital market falls, it's better to discuss a little about why the markets rise. Because that cannot fall which has not risen.

Well, there are different types of scripts.

Some are matured scripts which have little scope of further upwards movement in terms of price. They amble along nicely, without much fluctuation. Defensive stocks fall under this category. Stocks like ITC, L&T, Nestle etc. fall under this niche. Their price does not slide much because their product portfolios consists of items in which they normally have monopoly and huge market reach. These products, their pending orders, and market reach are not easily surmountable by other companies in same sector. Hence such stocks normally have continuous revenues, give constant and stable returns, good dividends and resultantly, their price do not fluctuate in extremes. Such type of stocks hold the market through thick and thin.

However, one type of vulnerable category stocks are the growth story scripts. Airtel was such a stock till two years ago before the onslaught of Jio. Sky was the limit for Airtel with scope of further penetration in Telecom, till Jio barged in. Growth stocks are those which have still scope of explosive earnings growth. Their price is still at a level from which people are willing to pay more for future better earnings prospects.
These are one line of stock which are vulnerable and can be one of the chief factors causing a market churn.
This happens when the actual trajectory of these growth stocks do not match the perceived growth story.
Sometimes, their story is disrupted by another company with superior offerings.

Another class of stocks which can cause flutter in the market, are the high beta scripts. Examples of such stocks are the realty, banking, nbfc etc. sector scripts. But these are basically trading scripts and whenever VIX rises or market shows symptoms of nervousness, these stocks are dumped first, fast. This selling adds further to market fall.

Banking stocks are a great contributor to the market liquidity. These constitute a large part of the banking index and several of them are blue chip stocks which are held in large number by the mutual funds.

A uptick in interest rate or upward revision of inflation generally causes heavy weight banking stocks like sbi, icicibank, hdfc and nbfc companies like reliance capital, shriram finance to fall rapidly. This happens because increase of interest rate or inflation means uptake of lesser loans. This translates to lesser NIMs or net interest margins.Also percentage of NPAs in bank’s portfolio increases which naturally decreases the stock price.

This increase of NPA sometimes weaken the bank's financial figures to such an extent that the government has to step in to provide additional capital to the banks in form of equity. This means increase in CAD, which makes rupee weaker and market slide.

Let’s now deliberate on what to do when the market falls. You will agree with me that it's better to bolt the door before the horse flees. In other words prevention is better than cure.
Before applying the vaccine, be on the lookout for the occurrence of symptoms of the disease.

The principle problem causing the market precipitation, as you know, is persistent high price. When somebody agrees to buy a share at a particular "ask" rate, there will be reasons why he is willing to do so. Principal of them are 2 reasons:

Capital gain in future due to revenue growth and consequent increase in net profit.

Reward in form of better dividends as the net profit increases.

A few traders start the trend by buying shares of a particular company or in general, the index shares. Buying the index shares cause the Nifty or Sensex to rise. Index shares are bought when one expects the general economy to rise due to lower inflation, low fuel prices, higher consumer and industrial demand.

Once the traders buys these shares, the news spread and buying momentum increases. It reaches into a cresendo when everybody feels left out and buys without looking at the financial parameters. High volume buyout of the index scripts buoys the index.

The index creates a new high as majority of the stock rises peeing to a common feel good factor.

Suddenly something happens out of the blue (price rise in crude oil owing to natural calamity, sanction, outage in oil drilling company etc., less rainfall than expected, rise of inflation in USA), in short anything, that crushes the dream future of the index scripts. The market falls ferociously.

So, what are the preventive measure you can take to avoid major meltdown of your capital during market fall?

Keep an eye on financial ratios like collective P/E and P/B of the market. Collective index P/E between 11 to 17 is okay, anything above that begs attention.

Collective P/B between 1 to 1.5 is okay. Anything above 2 warrants alertness in buying at that level.

Check out the index dividend yield. See if it's at attractive levels, before buying the stocks. One of the main reason for which investors buy stocks are the dividend. If the index yield is not attractive, it means most of the index stocks will not provide you an attractive dividend at the at price. Logically, then why should you at buy at that price?

These simple few steps would save you from a lot of heartburn later, when the market crashes. All because these tell -tell signs alerts you and you not to purchase any script at these elevated levels where risk to reward ratio is very high.

Another way to save your skin and even make some profit, when the market slides, is to buy a nifty or banking “put” option beforehand as an insurance. But it when the market is at irrational high and price of put low. This works particularly well if your bought shares capital is large. In case the market moves up, the rise in your investment amount will partially offset the decrease in value of put. If the market falls, the put premium increase will negate the mark to mark decrease in value of invested stocks.

However, options is a dangerous game and if you find that the market has every chance to fall more, it's better to sell your stocks at that still elevated levels and square the put too, whose premium increase will be the icing on the cake of your returns.

Gorge on dollars when the market is at irrational high. As the market will fall, foreign investors will flee, selling INR and buying USD in the process. Increase in value of USD will provide you a steady stream of capital even when the market falls. In fact, for you, buyer of USDINR futures in NSE or MCX-SX, more the market falls coupled with weakening of rupee, more the merrier.

Buy US equity based MFs or ETFs like e.g. Motilal Oswal Nasdaq 100 ETF which sports a three-year return of about 21 per cent or ICICI Prudential US Bluechip with 16 per cent average return over last three years. Franklin Feeder US Opportunities is also a viable option.

Normally when the Indian capital markets are up, they are available at decent valuation. However, once domestic markets plummet , these US based ETFs shoot up.

The above steps are effective in protecting you. Give the above suggestions due weightage, they in turn would allow that lovely smile on your face to remain there irrespective of the Sensex being at 36,000 or 26,000 or at 16,000.