This week’s Economist has a great article entitled “Turning Panic Into Opportunity”, which discusses what to look for when buying in a bear environment like we are facing today. Adapting the article to the Malaysian market, in summary the criteria proposed are:

1) Volatility: In the US, the VIX index measures the degree of volatility in the market. The theory is that this usually occurs in bear markets, because bear markets are the only markets when traders are forced to sell (i.e. to meet margin calls). That is why bear markets are much fiercer than bull markets. These forced sells cause prices to move fast and volatility to rise sharply. The article then goes on to imply that market lows tend to occur when when the VIX is at its highest (e.g. August 2002 when the hedge fund LTCM was bust and had to be bailed out, when the index reached 35) and extrapolates that perhaps when the VIX reached 31 a few months ago when Bear Sterns was bought out, this points to a similar market bottom.

I personally believe that this indicator is of limited use, because even though the VIX can confirm whether or not a bear market has taken place, it’s still better to look at stock prices themselves. When market events like the failure of LTCM or the rescue of Bear Sterns occur, you can bet that the Vix will shoot up, but that does not necessarily mean that the market is at its bottom. The market can still drift lower under low volatility like it has done since March for the financials. If anything I think it would be better to look at trends, like the moving average line. In doing that, we will see that the S&P is now trading at close to the similar average volatility to the dark days of 1998 and 2000-2002. In those days, the VIX index actually went significantly above the S&P and stayed there for a considerable amount of time, and if things are anywhere near as bad as they were then, according to that measure S&P has at least another 5-10% more to fall. But note that the comparisons against historical correlations should not really be relied on to guide trading decisions for the future as as the attached chart shows. Also, there is currently no volatility index for the KLSE, so we have used VIX which is for the US market. However, given the correlation between the US stock market and the KLSE, the approximation should be fairly reliable.

2) Yields: When dividends for stocks start to pay more than bonds, income investors will be lured into purchases. The theory is that dividends tend to increase over time, and so if the yield today for shares is greater than yields for long dated bonds, then that is a signal for long-term value on income. Today the Malaysian 10yr bonds are now yielding around 4.8% but the yield on the KLSE is around 4.1%. This suggests that a drop of another 10% -15% will make the KLSE attractive from that perspective. But beware that companies can cut dividends as earnings drop, especially in today’s environment when inflation is causing capex costs to rise dramatically.

3) P/E: A simple rule of thumb behind PE ratios is that it represents the number of years for a company to earn the amount of represented in its share price. Therefore a PE of 10 means that a company will take 10 years to earn back the share price on a per share basis. Anything below 10 means that the company is generating returns above 10%. A year ago, the PE for the KLSE was at 19. It is now at around 11. If it drops to 10 or below then the KLSE will start to look attractive from this perspective as well. Note however, that in a similar fashion to the above criteria earnings may also drop, causing PEs to rise even when the market is heading south. Some might argue that in today’s environment with inflation costs and political uncertainty that is exactly what is going to happen, but on the other hand if you believe in the prospect of falling oil prices and the contined growth of China and India feeding into the bottom line then you may not agree.

So whilst it is not possible to always time the market, I hope this article shows how best to position yourself in such a way that you can get a good deal in today’s falling market.