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Fear of Heights

Though declines have been sudden, Indian markets are far from being in bad state. It is time to think if your all-equity allocation matches with your risk appetite

A group of children are making their way through a haunted house. They're all scared-really scared-but they take courage from each other. Each shadow looks like a ghost and each creak like the breath of a witch. Bravely, they make their way deeper and deeper into the house, getting closer to the basement where there is said to be buried treasure. Each one would be embarrassed at being the first to run away so they all keep going. Suddenly, the wind rises and a door creaks. One child screams, turns and starts running. Suddenly, they're all running, trampling over each other as they rush to the front door to save their lives.

Isn't this what the world's stock markets look like right now? But in the markets' case, the story doesn't end here. Once the kids are out of the haunted house and into the bright sunshine, they feel courageous again and rush back in. And the cycle keeps repeating itself. Whether they ever get the treasure, we don't know.

Anyway, over the last two weeks some bits and pieces of news here and there have taken the shape of a monstrous ghost and investors around the world are running for cover. Now whether the ghost turns out to be a real one or just a flight of fancy will become clear in the coming days, but here are the all has gone into its making.

The Dragon Scare
The strong and ever-growing dragon has been the prime accused for the carnage. China's Shanghai stock index plunged 8.8 per cent on February 27, on rumours that the Chinese government is planning to introduce a capital gains tax to curb rampant stock speculation. The fall proved unnerving and fear gripped markets right from Japan to the US. In a chain-reaction, a sea of red spread across the globe.

Thanks to some ruthless selling by foreign institutional investors (FIIs), who sold stocks worth over Rs 3,000 crore in the four days to March 2, the Indian markets too sank. Sensex tumbled over four per cent on February 27, followed by another 5.21 per cent on February 28, to record the biggest single-day fall in over nine months since May 18, 2006.

The Greenspan Effect

Former Federal Reserve Chairman Alan Greenspan's bearish comments for the US economy served another blow to the sentiments. The talk of recession, coming from arguably the most credible figure in the economic circles of the world's largest economy, was enough to escalate the panic.

Though carefully worded, his statements clearly highlight the looming dangers he foresees. "When you get this far away from a recession, invariably forces build up for the next recession, and indeed we are beginning to see that sign, for example in the U.S., profit margins ... have begun to stabilize, which is an early sign we are in the later stages of a cycle," he said. "While, yes, it is possible we can get a recession in the latter months of 2007, most forecasters are not making that judgment and indeed are projecting forward into 2008 ... with some slowdown.”

Budget Blues
At a time when markets were desperately searching for some good, even a very modest budget could not escape the wrath. Budget 2007-08 did not unveil any drastic implications for corporate India at large except for some minor tinkering. Under normal circumstance, stability of policy should have been taken as a positive sign, but the markets punished the budget it with an over 5 per cent correction and the budget drew comments like 'unimaginative' and 'uninspiring'. And we thought no news was supposed to be good news.

Unwinding of Yen Carry Trade
Another reason for the sudden onset of fear is the implications that a large-scale unwinding of the yen carry trade could have on the global financial markets. For a long time, investors have been borrowing a low-yielding currency like yen, and investing it in assets promising higher returns. In a nutshell, borrowing cheap yen and investing more profitably elsewhere is what is referred to as yen carry trade. The strategy has been successful since yen had been weakening over the last few years. But going forward, this may not be the case and therefore, any gains made on the trades can get negated by adverse exchange rate movements, thus leading to unwinding of such positions and causing financial disruptions.

Putting Things in Perspective
Even though the decline has been swift and sudden, Indian markets are far from being in a bad state. Even after two weeks of an almost secular decline, shedding more than 10 per cent in the process (as on March 2), the Indian markets still have a healthy one-year return of 21.26 per cent. Extend your time horizon to 3 or 5 years, and the CAGR of the Sensex comes to around 30 and 28 per cent respectively. Therefore, things are definitely not as bad as they seem to be on first site.

See, nobody contradicts the fact that economies like those of China and India are doing well, and that their companies are expected to continue to grow at a fast pace. But the appreciation of their stocks is sustainable only when it keeps pace with the growth of the companies, not by surging an astonishing 130 per cent in a year, as has been the case with China. Does an 8.8 per cent decline look that unjustifiable then?

Still, the knee jerk fashion in which the global markets have reacted has caused panic all across. But as illustrated at the start of this story, the real devil lies in the psyche of investors. The uncertainty in the global markets is at its height. The US is gearing up for a slowdown. And as regards emerging markets like India, the growth story remains intact, but rich valuations are a source of dilemma. And to top it all, investors are sitting on fat profits, thanks to the bull of the last few years, which means that they really won't have to think twice before exiting the markets. The problem is just that they are unsure about when exactly will the tide turn. Against this backdrop, even slightly negative developments, which have the potential to escalate into a big downfall, can cause investors to sell. This seems to be the reason why the markets have reacted so sharply in the last few days. In such a scenario, it would've been hardly surprising had the markets fallen because of an event as unrelated as spotting of a UFO in Bermuda, instead of the rumours of a capital gains tax in China!

This also highlights the fact that as an investor, you should be prepared to witness such abrupt reactions going forward. A heightened volatility is something that you will have to cope with in days to come. Read on to find how you can do that.

Ghost-busting
For those who had started believing that stock investing is low risk, this should be a wake-up call. Equity is an inherently risky asset class and just because it has been secularly going up in the last four years does not mean that it will continue to do so till eternity.

The concept of asset allocation has long been forgotten, and equity has been the way to go for investors at large. The 'dull' and 'unprofitable' fixed-income investing just doesn't make sense. But this market fall highlights how much sense it makes.

If you find yourself too unnerved to see the returns of these last few months vanish in thin air, just sit back and think whether your risk appetite really justifies your all-equity allocation? If not, now is the time to make amends. A bank fixed deposit is offering over 9 per cent interest, which is not bad at all. Therefore, the most important task at this stage should be to set your asset allocation in place. Only the money that you will surely not require for at least the next three years should be in equities, while the rest should be fixed-income instruments.

The other important thing is to stick to the time-tested way of equity investing- systematic investment plan. That is the only sure-shot way to ensure that the 'ghosts' of stock markets don't come haunting again!