Was it just a market correction?

The recent and ongoing sharp correction seems to have engulfed the market in fear and panic. Many investors are now fearing that the bull run has come to an end, and that the glory days of easy money making are over.

As is typical when markets begin to fall, all the proponents of doom and gloom come out of the woodwork, and now people are talking of the markets declining to below 9,000 (BSE Sensex).

Some market gurus have once again begun to talk about the fact that globally we are still in a secular bear market, and that the last couple of years was only a temporary lull before the bear reasserts itself.

Is this really the end? Has India once gain succumbed to the curse of shooting itself in the foot, this time led by the move on reservations and some misreporting on overzealous tax officials?

First of all, it is important to set the context and understand what is really going on.

This is not an isolated correction in India alone; risk taking globally is in retreat, and most risky asset classes are under pressure.

Emerging market equities are down 12 per cent, about the same as in May 2005, and even more so than the 8 per cent correction of October 2005. Asian equities have been equally hard hit, down about 11 per cent in aggregate, led by India and Indonesia, down 17 per cent and 16 per cent, respectively.

The correction has been triggered by a reversal of foreign flows into the region as over the past couple of weeks almost $8 billion of capital has been pulled out of Asia, compared with a net inflow of almost $20 billion year to date.

The pressure has been caused, primarily (to my mind, at least), by markets beginning to understand that inflation could be a greater risk than they had priced in hitherto. There is a distinct possibility that the "goldilocks" scenario, wherein the Fed is able to slow down the US economy just enough to quell inflationary pressures but not kill growth, may not come to pass.

Stagflation, wherein the Fed has to raise rates significantly to fight inflation, and kill off economic growth as a consequence, is no longer as far-fetched a scenario as once thought.

Markets are naturally fearful of any further prolonged tightening from here, even more so when healthy gains need to be protected. (Asia was up 20 per cent, before the correction set in).

Others attribute the sell-off to a reversal in commodities and some talk about currency movements being the culprit. Whatever be the cause, the fact is that, investors are nervous and once again beginning to understand the concepts of risk and volatility.

India understandably has got hit very hard in this downdraft, as speculation was rampant and the markets were clearly highly overbought. Signs of excess were everywhere, with record inflow into mutual funds, property stocks going ballistic, and greed overpowering fear. Whenever money making becomes so easy it can never last long.

As many observers have pointed out, our markets and real economy both are high leveraged to foreign flows, and thus any reversal of risk appetite hits India more than most. Having tripled over the last three years, the gains on the table in India are also greater than most other markets.

The question facing investors is the outlook from here: Is this just a correction, or should they fold and take whatever gains they have left?

I personally think the foundations of this bull market in India are based on three long-term secular trends.

There is an ongoing shift in asset allocation among institutional investors globally, away from the listed developed markets towards either unlisted alternatives or international equities (specifically emerging markets).

This shift is structural, given the need for higher returns, and is nowhere near complete. The sheer size of this potential shift in terms of the quantum of money that will be needed to be redeployed is enough to give a strong multi-year tailwind to emerging markets in general.

The G-7 financial markets are unlikely to be able to deliver anything more than low-single digit real returns (at best). These returns are insufficient and thus institutions of all types need to expand their investment horizons in search of returns.

India has now entered a new growth trajectory of 7-8 per cent real GDP growth. A decade of 7.5 per cent growth will transform this country and throw up huge opportunity across sectors.

A GDP growth rate of 7-8 per cent should allow market earnings to grow at 15-17 per cent. India also has arguably the strongest and deepest entrepreneurial culture in Asia, and will continue to develop, grow and list world-class companies.

Given the quality of Indian companies, their ability to generate world-class RoEs, and the huge runway for growth, India will and should trade at higher than mean emerging market multiples.

The Indian household is underweight on equities, especially when compared to its own past history. As demographics and economic growth combine to supercharge our pool of domestic savings, domestic flows into equities either directly or through funds will explode.

This will be the ultimate and final leg to this bull market, when domestic flows and institutions will overpower the foreigners. It will happen; it is only a matter of time.

I think one should bail out of the markets only if one firmly disbelieves any of the above core operating assumptions.

For, if these assumptions are right then we are in the midst of a long-term structural bull market in India, and while short sharp corrections of 15-20 per cent can and do happen (even in secular bull markets), the patient investor will benefit by riding through this volatility.

Already down 17 per cent as I write this column, by historical standards, if this is only a correction as I suspect, the markets must be very near to bottoming out. While the markets after stabilising are unlikely to immediately rocket back above 12,000 (Sensex), they should remain in a trading zone as earnings catch up and investors consolidate.

There are many who believe that India is more hype than substance, pointing to our binding infrastructure constraints, inability to move ahead on economic reforms, lack of sufficient domestic savings and complacency.

Many believe our potential will never be realised. These investors were in India to play momentum, the markets were hot and could not be ignored, but they have no long-term belief or interest in the country.

This is when markets truly test conviction. Do you really believe in the India story? Do you think that we are at an inflection point in India's economic history?

If yes, then be prepared to ride out some short-term volatility, but keep buying selected growth stories on the way down.

If you were only here to play short-term momentum, then that game is pretty much over and done with, and you should be looking for the exit door at the next bounce back.

Sensex Rise and Fall: Complete Coverage