How long and deep the ongoing correction will last?

One of the leading financial services and research firm, Morgan Stanley said its operating assumption is that the ongoing fall in the market is a correction of the bull market that began in March 2009. Indeed, given where the growth cycle and equity valuations are, it seems to be a reasonable assumption. What is history`s guidance on how long and deep the ongoing correction will last?

Morgan Stanley goes back 17 years of market (BSE Sensex) history to assimilate data on bull market corrections.

Here are the observations from history:

a) There have been four bull markets over the past 17 years (including the current one), and within those bull market there have been 30 corrections of 5% or more (including the current one).

b) The average fall during these corrections has been 13%, and the average duration of these corrections is 17 days. The worst fall (May-June 2006) was 31%, whereas the longest fall excluding the ongoing correction (July to September 1993) lasted 28 days. The standard deviation from the average fall is 5.6%.

c) The average realized inter-day volatility during corrections is 1.6% slightly more than the average during rallies.

d) The subsequent rally post the correction produces an average return of 31% over 48 days. e) India has historically underperformed emerging markets during corrections and outperformed on rallies, save for a couple of occasions.

f) It is not that FIIs are always sellers during corrections. They have been net sellers in 12 out of the 30 corrections (including the current one). Indeed, on a cumulative basis, FIIs have sold USD 6.6 billion of stocks over the past 30 corrections. FIIs have sold USD 515 million of stock in the current correction.

g) The BSE Sensex has fallen below its 200 DMA only on two occasions during these 30 corrections, i.e., in 2004 and 2006. Over the past 30 years, the market has penetrated its 200 DMA four times during a bull market with an average fall of 9.3% below the 200 DMA with the average time spent below the 200DMA being 46 days (excluding the ongoing correction).

h) There is no clear cut message from the valuations at which the market troughs, i.e., the valuation range is 11x trailing earnings to 45 times, with the average over 30 corrections being 20 times trailing earnings. We are currently at 21 times trailing earnings.

About the ongoing correction:

a) It is the longest bull market correction since FIIs starting investing money in India. This correction has already 33 days old exceeding the previous longest correction by five days.

b) The fall is in line with the average and ranks 15th in the pecking order of corrections. If the market finds a floor at one standard deviation below the average fall of the past 17 years, it could take the BSE Sensex to 14,800.

c) This is only fifth occasion in 30 years that the Sensex has fallen below its 200 DMA. As of yesterday`s close, the BSE Sensex is 4.5% below the 200 DMA and the index has spent five days below the 200 DMA. If this fall below 200 DMA matches the average of the previous fall, the Sensex will trough at 15,200.

Conclusion:

The domestic macro is strong, and the government continues to push reform (the recent gas price increase is an example). The 3G auction proceeds imply that the government`s fiscal deficit targets will be met, even exceeded, easing the pressure on the 10-year bond yield - setting the road for a bullish flattening of the yield curve. Earnings continue to be strong, with two out of three companies surprising positively in the ongoing earnings season. The fall in crude oil prices increases the chances of a decontrol of auto fuel prices. The settlement of the Ambani family dispute should also be a positive for the market, in its view.

India`s defensive behavior through the latest bout of global turmoil seems to be driven by a combination of an improving policy environment, resilient domestic growth, healthy corporate balance sheets, an improving government balance sheet and a central bank that has not been hesitant to raise rates to ward off inflation threats. Thus, the logic that India should have suffered more than the average of emerging markets, given how its external deficit is funded, has been defied, and this has come as a surprise to it. Only if the European crisis deepens further (not its base case) will India struggle to retain its defensive response to this global development, in its view. Its view is that unless this is the start of a new bear market, the ongoing correction is a buying opportunity. Its base case is that this is not the start of a new bear market.