Fiery Friday! Sensex loses 900 points in one day. What took Sensex 6 days to climb up took a minute to come down! Seven days of relentless selling scares investors!

These are some of the headlines that those reading newspapers and watching TV might have seen over the last few days. There is no doubt that this correction was the most anticipated one. However, when reality struck, it has disconcerted investors. The question in your mind could be “Is this a correction? Or a trend reversal?” Let me answer that for you — It is a correction!

Attention, new investors

As stated in our annual outlook in the first week of January, the dispersion for the year 2017 was 7.4 per cent (as measured by the gap between largest monthly gain and largest monthly draw down). This was the lowest in decades! The fear gauge as measured by Nifty VIX Index has been trading between 10 and 15 during most of the entire year, indicating no or low fear in the markets.

While most were calling for a correction, it was not coming through. The year 2017 was not normal in equity markets and the new investors who have entered into markets in the past year have to acknowledge that.

Reasons for correction

The recent correction of 8 per cent in the first few days of February ’18 was due to two reasons. In the US, the 10-year government security is expected to hit 3 per cent (already at 2.8 per cent + handle) which would increase the discounting rate used for stock analysis and would lower valuation given to stocks.

The markets anticipates that the higher interest rates could slow down growth. In Indian markets, the implementation of long term capital gains tax (LTCG) has led to adjustment of return expectation. As investors were settling somewhere between lower expected returns and lower realisable returns, markets corrected.

Lessons from past corrections

In the midst of the raging bull market of 2003-08, May-June 2006 has seen markets correct by 31 per cent.

This was due to the concern that the Chinese economy could see a hard landing. It took over four months for the markets to recover the drawdown. In fact, during the five-year bull market, there were 13 instances of over 10 per cent corrections.

More recently, during the four months leading into February 2016, the markets corrected by nearly 20 per cent on the back of a global slowdown due to global deflationary pressures. It took three months to retrace the correction. This kind of volatility could be back and investors have to be aware of that.

What is the prognosis?

As the 10-year government security in the US moves towards 3 per cent, there is a possibility of markets losing steam further. Though there is no evidence of rebalancing yet, there is a risk of asset class switch from equity to debt. Since Indian markets also track global markets quite closely, the former may participate in the correction if the US corrects.

In the near term, the expected return adjustment due to LTCG would continue. Due to the dividend distribution tax on dividends paid by equity oriented funds, flows in balanced category may slow down. As bond yields in India have backed up by 100 bps, the flow coming into equity funds may slow down, finding its way into fixed income.

After the above adjustments, the current run rate of ₹20,000 plus crore per month into equity and equity oriented funds could slow by approximately 20 per cent. Even then the flows remain healthy in terms of providing domestic liquidity.

Like seen in the previous and current bull market, the corrections could be severe and the recovery could also be fast-paced. The combination of higher earnings growth and attractive valuation would provide a secure downside.

Why is downside secure?

The world is witnessing synchronous growth in both developed and emerging economies. In India, after the twin effects of demonetisation and GST, growth is coming back. Various estimates from both domestic and international agencies put India’s GDP growth much in the 7 per cent plus handle. This would be led by consumption and exports.

Due to the firing of the two engines of GDP, we would see capacity utilisation going up, necessitating private capex. It is being made possible by lower leverage and higher free cash flow among companies.

The recent Budget reiterated its focus on stressed sectors like rural and small businesses, which augurs well for growth. Corporate earnings are running above estimates for the third quarter.

Among Nifty 50 companies, more than two-thirds of the companies have beaten expectations. We expect the Nifty 50 companies to grow their EPS by 10 per cent in FY18 and 19 per cent in FY19.

What should investors do? Keep your SIPs coming in. It is time to start nibbling and use further weakness in markets to add more positions. Time to brace yourself and be watchful!

Mutual Fund investments are subject to market risks, read all scheme related documents carefully.