For investors, there could be no better proof of the compelling need to tread cautiously in the equity markets than the wide swings seen in market movements between Thursday and Friday.
On Thursday, a market that is currently seen as fragile on sentiments, first rallied by 684 points (the BSE Sensex rally) to close at a three year high in the wake of the US Federal Reserveís decision to not tinker with its bond buying program.
Just 24-hours later, it went on to fall by 1.9 per cent or 383 points (fall in the 30-share Sensex) on Friday, after Raghuram Rajan surprised the market and raised the repo rate (at which RBI lends to commercial banks) by 25 basis points, primarily with a view to bring inflation down to tolerable levels.
The takeaway from the over-the-top market behaviour in the last two trading days ó do not get excited by a sharp rally in the markets while not losing your heart and exit when it goes down. Investors should on the other hand follow the opposite, accumulate further when it falls and use the opportunity when it rises to book some profits.
The uncertainty in the market is unprecedented and investors need to look at staying safe with debt ó both short term and long term fixed income instruments or fixed maturity plans ó and wait for the tide to settle down before venturing into equities.
India and the global economy
When it comes to the macroeconomic situation, both in India and the global economy, the outlook continues to be fragile. Since the RBIís first quarter review in July, a weak recovery has been taking hold in advanced economies, with growth picking up in Japan and the UK and the euro area exiting recession.
However, activity has slowed in several emerging economies, buffeted by heightened financial market turbulence on the prospect of tapering of quantitative easing in the US. The decision by the US Federal Reserve to hold off tapering has buoyed financial markets but tapering is inevitable.
On the domestic front, growth has weakened with continuing sluggishness in industrial activity and services. The pace of infrastructure project completion is subdued and new project starts remain muted.
Consumption, while relatively firm so far, is starting to weaken even in rural areas, with durable goods consumption hit hard. Consequently, growth is trailing below potential and the output gap is widening. Some pick-up is expected on account of the brightening prospects for agriculture due to kharif output and the upturn in exports.
Wholesale Price Index (WPI) inflation, which had eased in Q1 of 2013-14, has started rising again as the pass-through of fuel price increases has been compounded by the sharp depreciation of the rupee and rising international commodity prices.
The negative output gap will exercise downward pressure on inflation, and the process will be aided as supply side constraints, especially relating to food and infrastructure, ease. However, the current assessment is that in the absence of an appropriate policy response, WPI inflation will be higher than initially projected over the rest of the year.
What has been raised a worrisome is that inflation at the retail level, measured by the Consumer Price Index (CPI), has been high for a number of years, entrenching inflation expectations at elevated levels and eroding consumer and business confidence.
On the external side, weakening domestic saving, subdued export demand and the rising value of oil imports ó most recently due to geopolitical risks emanating from West Asia ó have led to a larger current account deficit (CAD).
Concerns about funding the CAD, amplified by capital outflows precipitated by anticipated tapering of asset purchases by the US Fed, increased the volatility in the foreign exchange market.
The causes for uncertainty
On the global front, the Fed will meet in December again and one will have to wait to see if it takes a call on tapering (or scaling back) of bond purchases worth $85 billion every month and the global crude prices continue to remain at elevated levels.
The reason for the Fed putting off its tapering schedule was because the US economy continues to remain weak and there are a few potentially significant risks in doing so. The biggest impact of the Fedís tapering schedule is likely to be felt by financial markets in emerging markets, which have become so accustomed to the Fedís easy money policy that the addiction is deeply ingrained in the stock valuations.
What is certain, though, is that the Fed cannot continue expanding the money supply at the current rate. The question, then, is when will the Fed begin to taper? Experts say December, but thatís during the peak of the holiday season, a period when the economy typically does well.
US-based fund analysts say this ďseasonalityĒ makes it difficult to determine if the economy is really improving or just experiencing a Christmas boost, thereby making the possibility of the Fed pushing it back until early 2014 a distinct possibility.
The uncertainty of the entire exercise makes the possibility of more gyrations in the emerging economy markets, especially equities, a real concern.
In fact, in Fridayís monetary policy announcement, RBI Governor Raghuram Rajan asserted that the Fedís decision to put its $85 billion a month bond-buying programme was just ďa postponementĒ, even as he stressed on the need to prepare ďa bullet-proof national balance sheetĒ, especially in the context of the general elections looming large.
On the domestic front, market experts maintain that structural uptrend in this sort of a market could precipitate when the interest rates are low and the return on equity rises, which will happen only when corporate profits go up.
As nothing has changed fundamentally for the economy, and the rise in the markets seem to be only driven by sentiments, the sustenance of the surge in equity markets is unlikely. Therefore investors should not venture to play in the markets on a sharp rally.
The research head of a leading global financial services firm said that the second quarter results will be disappointing and therefore the earnings of companies are not expected to witness any growth which can prove to be another major dampener for the markets.
But experts suggest to book some profits when the markets rise and Thursday offered one such opportunity. The rise on Thursday, which took the Sensex to a near three year high and also much closer to its all time high levels, provided investors a good opportunity to book profits.
While the market was enthused and rose swiftly after Fedís announcement, there is a broader sense in the market that the momentum cannot be sustained unless things start changing on ground for the Indian economy.
The Short Term Bet
There are hopes that the US Fedís decision to continue with easy money policy will lead to an inflow of funds in the emerging markets including India and will also stop the outflow of funds for now. However, while that may be true till the US announces to scale back of its bond purchase programme, the minute there is an indication of it happening, the outflow of funds could commence.
Investors should therefore avoid falling into the lure of playing with stocks and wait for the structural improvement, such as interest rates going down and corporate earnings improving, before they go for big-ticket investments in the market.
Try to be safe, continue with your equity SIPs and allocate higher component of your portfolio in the debt markets until structural changes happen.