Since the beginning of the year markets have been very volatile all over the world driven primarily by high inflation, spike in bond yields, persistently rising crude oil prices as well as geopolitical news flow. Historically geopolitical news flow has had a short term impact on the markets with no sustainable long term impact. However higher interest rates and reducing liquidity impacts risky asset pricing in many ways along with potentially slowing down economic growth.

At the beginning of the year my view was that the first half of the year will be tough for Equities and followed by a revival in the second half. Overall higher interest rates will become restrictive for economic growth potentially after 2-3 years and as such there will continue to be opportunities in the markets. However valuation impact will be significant as this time unlike normal monetary policy cycles Where is also the unwinding of the huge balance sheets of central banks which will play out which was not a feature of the previous cycles. This puts a huge unknown into the system as asset purchases drove down interest rates much below where normal monetary policy would have driven them to thus boosting excessive risk taking as well as pushing various assets be it traditional assets like equities, commodities and bonds to the new age assets like cryptocurrencies, NFT’s, assets in the metaverse etc. to gravity defying valuations.

The problem with this scenario is that newer investors have got into the new asset classes which have only gone up and not seen any big downside cycle over the last 2-3 years and due to the sheer liquidity floating around and extremely low interest rates there has also been an element of leveraging which leads to losses multiplying as prices move on the other direction. Even in traditional assets like bonds, given the sheer pace of up move of bond yields the losses that bond investors will need to take will be very huge this year.

A part of this risk has got factored into the markets, however in my opinion not enough at this stage. For example from the beginning of 2022 the Dow Jones Industrial is down around 2000 points i.e. 6% and the Nasdaq Composite is down around 12%. However the Russel 2000 peaked out in November 2021 itself and is down around 15% from those levels. While these corrections might look substantial they are small relative to the up move that has played out since March 2020. The cuts in most Emerging Markets in general are much deeper with many hovering a few percentage points above the 52 week lows. As such valuation adjustment in most Emerging Markets has been quite significant. Indian Markets on the other hand have largely held on despite valuations now being the highest in the Emerging Market universe and valuations premium of the Indian Markets over EM’s at the highest in history.

Foreign investors have been continuous sellers in the Indian Markets for several months now. However domestic flows into equities via Mutual Funds, Insurance Companies as well as direct inflows have been very strong. This is one of the reasons why markets have held on so strongly. However markets are a slave of earnings eventually and valuations do matter. The best part for India at this stage is that most of the large banks and financials have got clean balance sheets, high capital adequacy and an ability to lend. This will support economic growth as it takes off. The bad part is that inflation is very high irrespective of what official data shows. Most companies have hiked prices substantially and high inflation normally hurts consumer demand which is also reflected by many companies in their conference calls. Pass through of crude price hike has also been stalled to the state government elections which will further hurt consumer pockets.

In this kind of situation the window of opportunity for investments as well as the opportunity set overall reduces. There is also likely to be a shift towards more of capital goods, infrastructure, housing and water, solar and green energy etc. related companies which will be the focus of the government in the runup to the 2024 elections.

There is one view in the markets that the impact of potential US Fed as well as other central banks tightening has already been built into the markets. Normally things get built in prior to the event however this time I do not think that the markets are building in the pace of monetary tightening which is going to happen. Also the speculative intensity in assets like Cryptocurrencies, NFT’s etc. is so intense that if these asset prices burst it will have repercussions across the board.

As such I believe that the next few months must be treated with caution. There will be specific opportunities in very strongly performing companies and sectors, there will be opportunities as particular sectors and stocks get sold down on market panics as well as when leveraged players are forced to exit positions due to sudden market moves and this will provide opportunities. This strategy involves keeping cash on the sidelines which should be at least 20-30% of capital. The reason cash is important is that it sometimes becomes difficult even for professional investors to decide what to sell to buy some great idea when opportunity comes. In any case there is no case for a runaway up move in the markets and thus having some cash does not hurt anyone.

In the last one year the worst month for the markets has been November 2021 when markets fell by 3.9%. As such a belief that markets cannot fall is very high in the minds of traders and investors. Historically most years have got months with 7-10% corrections and some with more than that.

It is also important to sometimes exit when valuations are abnormal. The best example of this has been the newly listed Next Generation Technology intensive stocks which have lost 50-70% of their value from the peaks in just the last 2-3 months. Although I don’t like most of these stocks in general at some price they might also become a buy.

Normally time in the markets is a good philosophy to follow, however timing also matters to buy the right kind of stocks at the right time for the long term and exit other stocks where valuations become so high that return potential over the next 2-3 years also does not exist.