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Every investor, seasoned or not, cannot avoid bull and bear markets. They are part and parcel of equity investing. These cycles are intrinsic to how financial markets operate. The inevitability of these cycles cannot be demonstrated better than the historical peaks and troughs of the Sensex:
1980: Began at 120 points.
1986: Reached 600 points, a 400 per cent leap!
1992: Peaked at 4,400 during the Harshad Mehta bull run.
2000: Tech euphoria fuelled it to 5,900.
2001: Dropped to 2,600 after the tech bubble burst.
2008: Hit 20,800 before the global financial crisis.
2009: Crashed to 10,400 during the global real estate crash.
2020: Covid crash plunged it nearly 23 per cent to 29,460 in March 2020.
2024: Surged 3.3 times since March 2020 lows to above 85,900.
This shows that markets move between exuberance and caution. But despite setbacks, equities demonstrate strong and consistent growth over the long term.
What causes bull and bear markets?
Bull markets typically kick off when investor expectations turn optimistic based on economic strength, industry growth, and profitability.
As these conditions persist, speculative behaviour takes over. Many investors only focus on the rising prices and end up ignoring the underlying businesses. As a result, capital influx pushes prices higher.
However, over time, expectations begin to surpass what companies can realistically deliver, stretching valuations. This disconnect between price and underlying fundamentals sets the stage for an inevitable correction.
Bear markets are generally triggered by inflationary pressures, rising interest rates, or broader economic slowdowns that reduce corporate earnings and growth prospects. As the outlook weakens, a broad sell-off begins. Bear markets, though feared by many, play a vital role in rebalancing the market by deflating speculative bubbles and resetting valuations.
Capitalising on market phases
To become an astute investor, it's important to know how to use weak market conditions to your advantage, and how to avoid speculative rallies. Here's what you need to keep in mind:
- Not fearing broad sell-offs: During a bear phase, investors are gripped with excessive fear, leading to intense declines, like seen during the tech bubble burst, real estate crash, and Covid pandemic. Such events create golden opportunities as companies often trade at significant discounts, even when many are fundamentally strong. Thus, it's crucial to remember that broad downturns are caused by industry or economic slowdown, not because every listed company has become financially weak. This is the time to spot great businesses with real long-term value.
For instance, during the Covid pandemic in March 2020, the country's largest jewellery retailer, Titan, saw its stock price plummet nearly 36 per cent, with a P/E ratio of 47 times—one of its historically low valuations. Since then, it has rebound and delivered a 40 per cent annualised return! - Harnessing temporary corrections: Even during a bull phase, temporary corrections occur as investors engage in panic selling sometimes. They are usually triggered by disappointing earnings or other unfavourable news. Such dips don't reflect the actual impact on fundamentals. Instead, they're emotional reactions to market noise. So, investors must not be thwarted by these temporary drawdowns. They should rather use these dips to add stocks whose financial strength is unchanged.
Take the case of pharma giant Divi's Laboratories. Between December 2016 and May 2017, its stock crashed around 50 per cent after a warning from the US FDA. Consequently, the P/E dropped from 28 to nearly 15 times!
However, the fundamentals of the company were strong, and the warning didn't significantly affect its long-term business potential. If you had done your due diligence and recognised this as a buying opportunity, your investment in the stock would have multiplied 10 times by now! - Avoiding the frenzy: During a bull phase, share prices reach historical highs and even touch new records. The rise of speculative activity results in investors chasing stocks based on momentum rather than business fundamentals. This inflates valuations beyond historic multiples. This is when investors need to up their guards and evaluate whether the rally is supported by just reasons. They should avoid getting swept up in the frenzy of overpriced stocks and instead focus on companies that are overlooked by the crowd (potentially undervalued securities).
Zomato is an example of investor exuberance. With just one year of profitability since its inception, the share has shot up nearly six times in the last one and a half years. Its revenue grew 56 per cent annually in the last five years. However, with a hefty P/E of 430 times, this might be a pricey affair!
Your takeaway
Bull and bear markets are natural components of the investment cycle, and neither should be feared or celebrated in isolation. Success in investing hinges on understanding these cycles, recognising market conditions, and adjusting strategies accordingly. Investors who stay grounded, maintaining discipline during euphoric bull markets and exercising patience during bear phases, are best positioned to succeed over the long term.
As storied investor Warren Buffett wisely said, "Be fearful when others are greedy, and greedy when others are fearful." By following this philosophy, investors can navigate both bull and bear markets with confidence, ensuring consistent growth and wealth accumulation.
Also read: Must-follow investment principles for smart investors
This article was originally published on October 04, 2024.
Disclaimer: This content is for information only and should not be considered investment advice or a recommendation.
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