Navigating Market Corrections

The Indian equity market has recently been caught in a downward spiral. This has made many investors slip into a panic mode so that selling has become the norm. This article therefore seeks to unpack the reasons behind this recent fall and offers a perspective on how corrections are integral to the market cycle. It also explores strategies that investors can adopt to weather the storm and emerge unscathed [EasyDNNnews:PaidContentStart]

The first week of October saw a dramatic reversal in the Indian equity market, with the benchmark indices taking a sharp nosedive. Between September 26 and October 7, Nifty 50 plummeted by over 1,400 points – a steep decline of more than 5 per cent in just under two weeks. This correction stands out as one of the most severe in recent months, occurring over such a short period. What makes this drop particularly different is that it wasn’t triggered by a global market downturn, like the one witnessed at the start of August. 

Instead, the Indian equity market emerged as one of the worst performers among major global indices during this period because of a confluence of factors. While Nifty 50 tumbled by 5 per cent, the markets in China and Japan showed resilience, gaining as much as 2 per cent and 7 per cent, respectively, over the same span. The chart below highlights the stark contrast in returns across the key global markets during this period, underscoring the unique pressure faced by Indian equities represented by Nifty 50. 

While volatility is an inherent part of the market, such corrections often leave investors questioning how to handle their portfolios in the face of such a sharp decline. After initial resistance, the broader market too saw a large fall. This article seeks to unpack the reasons behind this recent fall, offer a perspective on how corrections are integral to the market cycle, and explore strategies investors can adopt to weather the storm. 

Understanding the Recent Market Correction The correction we witnessed in early October can be attributed to a confluence of several macroeconomic and geopolitical factors: 

1. Geopolitical Tensions in the Middle East - The ongoing tensions in the Middle East between Israel and Iran have heightened uncertainty in the global markets. The escalating tensions have had a significant impact on the global financial markets, including the Indian equity market. The Middle East is a major source of global oil supply. Any disruption to oil production or transportation due to conflicts can lead to a surge in crude oil prices. This, in turn, can negatively impact India, a major importer of crude oil. 

2. Foreign Institutional Investors (FIIs) Sell-Off - A major factor behind the recent market correction has been the significant selling pressure from the FIIs. Their net outflows intensified the downturn, despite domestic mutual fund inflows offering some degree of support. Over the last 10 trading sessions ending October 11, FIIs offloaded domestic equities worth `69,396 crore, marking one of the largest sell-offs in recent memory. The last time the FIIs sold shares so aggressively was during the height of the pandemic in March 2020, when they pulled out `65,817 crore in a single month. In the last ten trading sessions, we have not seen a single day when FIIs have net inflows to the Indian equity market.  

3. Chinese Market Stimulus - One of the reasons for such a hasty exit of the FIIs from the Indian markets was that they are now allocating these funds towards the China market. China funds garnered a historic high flow of USD 6.2 billion in the week ending October 4, bringing the total flows over the past two weeks to USD 7.2 billion. Foreign flows into Indiadedicated funds, on the other hand, decelerated to USD 107 million, compared to an average of USD 300 million over the past two months, according to data from Elara Capital. The reason for such change in heart of the FIIs includes the stimulus package announced by the Chinese government in September 2024, which was estimated to be around USD 283 billion. 

This figure was based on projections from various analysts and economists who anticipated that China would deploy significant fiscal stimulus to boost its struggling economy. This included monetary policy adjustments (cuts in interest rates and reserve requirements), increased government spending on infrastructure and social safety nets, and measures to support the property market by lowering mortgage rates and reducing down payment requirements. China’s struggles, particularly in its housing sector, have weakened consumer sentiment, contributing to lower consumption and investments globally. 

Besides, there is a huge valuation gap between the Indian and Chinese equity markets. As of September 2024, the valuation gap between the Chinese and Indian equity markets remains quite wide. China’s benchmark index, the Shanghai Composite, is trading at a forward PE ratio of around 10 times, reflecting weak economic sentiment and concerns over the country’s slow post-pandemic recovery. In contrast, the Indian equity market, led by Nifty 50, remains buoyant, with a forward PE ratio of 22 times, supported by strong economic growth and robust corporate earnings. Post this stimulus, the Chinese authorities are trying to correct their economic stagnation and hence we saw the FIIs investing in the Chinese equity market resulting in better returns. 

However, all said and done, Indian investors need not be overly concerned about the recent stimulus in China or the outflow of foreign institutional investors (FIIs). Despite the current excitement surrounding China’s stimulus-led rally, data from one of the leading brokers for the period ending September 2024 suggests that a majority of the top emerging market (EM) funds remain underweight on China. In fact, 90 per cent of the top 30 largest EM funds have minimal exposure to China, and across 450 EM funds, the median underweight on China stands at 3.1 per cent. This indicates that most foreign funds are not significantly reallocating towards Chinese equities. 

The concerns about a ‘Sell India, Buy China’ trend appear overstated. While China has seen a short-term boost following its stimulus measures, the 52-week low and high in a matter of couple of weeks indicates volatility in the Shanghai Composite and Hang Seng indices. On the other hand, the Indian market’s performance remains steady and in line with global trends. Importantly, foreign inflows into China have only recently hit a 14-month high, but this is largely attributed to domestic factors. 

Historically, when foreign investors exited China, much of that supply was absorbed by the domestic players. Therefore, the Indian markets continue to offer solid long-term growth prospects, and investors should remain confident despite temporary shifts in global capital flows. 

4. SEBI’s Derivatives Trading Changes - Another probable reason for such a fall can be attributed to the regulatory body’s recent announcements around derivatives trading, which aim at curbing speculation and reducing market volatility in the long run. However, in the shorter run it may lead to higher volatility due to adjustments required by the market participants to adjust to the new rules. 

Historical Context of Market Corrections
Corrections are a normal part of the market cycles. Historically, markets tend to correct by two to three times by 5 per cent every calendar year, while larger corrections of around 20 per cent are also not uncommon and keep happening every two-three years. These fluctuations are not anomalies. Rather, they are necessary for healthy market functioning and often provide buying opportunities. The last time we saw a correction of more than 5 per cent in Nifty was post the June 2024 election, which the market recovered within three days. 

Prior to that, in October 2023 we saw a correction of 5.25 per cent, which was recovered in 37 trading days. The graph below shows all the drawdowns of Nifty 50 since June 2007 that were greater than 5 per cent and their recovery time. It also includes those periods where the market has fallen by more than 5 per cent. So, in 2008, during the global financial crisis, we saw Nifty falling by more than 50 per cent and similarly during the corona virus pandemic market crash, Nifty fell by more than 30 per cent, which is captured in the following graph. 

The last significant correction in the market we saw was in 2022, which was triggered by rising inflation concerns following the Russia-Ukraine war, which was recovered in 175 days. Yet, over time, the Indian market has shown resilience, buoyed by domestic inflows into mutual funds that have countered the FII outflows. 

Why Corrections are Healthy
Despite the pain of seeing portfolio values fall, corrections are essential for maintaining the health of the financial markets. They help reset inflated valuations, bringing stock prices closer to their intrinsic values and prevent the formation of speculative bubbles. For long-term investors, corrections offer an opportunity to buy high-quality stocks at discounted prices, as many strong companies see temporary price declines due to the overall market sentiment rather than any deterioration in business fundamentals. 

Corrections also serve to cleanse the market of weak players, while reinforcing disciplined investing practices. By shaking out speculative behaviour, they restore a more sustainable and realistic approach to investment. While unsettling for some, corrections are a natural part of market cycles, offering valuable lessons for new investors and creating a stronger foundation for future growth. 

How to Prepare for a Meaningful Correction
The recent decline, while sharp, is still relatively shallow. A more meaningful correction could be on the horizon as the tension in the Middle East escalates or some other black swan event occurs. So, how should an investor prepare for such an eventuality? Below are some key strategies: 

1. Re-Evaluate Your Portfolio - Market corrections offer investors a valuable opportunity to reassess their portfolios. During these times, it’s essential to consider if certain stocks have surged too quickly and become overvalued or if the underperforming sectors should be trimmed. Rebalancing your investments to stay aligned with your long-term goals is crucial during periods of market volatility. A significant shift has unfolded recently, particularly in the performance of public sector undertakings (PSUs), especially in defence and railways. The strong momentum in PSU stocks, which had built up ahead of the general elections in June 2024, has faltered in the post-election period, leaving investors questioning the road ahead. Available data shows a stark difference in the performance of these stocks before and after June 4, 2024, when election results defied exit poll predictions. Prior to June, the BSE PSU index significantly outperformed the BSE 500 index, posting a 43 per cent return since the start of the year, compared to the BSE 500’s 12 per cent rise. However, post-June 4, CPSEs have underperformed, delivering only 6 per cent gain, while the BSE 500 achieved 14 per cent return during the same period. This trend is evident across the top 20 PSU companies by market capitalisation. While the pre-June performance was remarkable, with several companies showing double or even triple-digit gains, the momentum slowed considerably after June. For example, the State Bank of India recorded a robust 41.10 per cent return before June but saw a slight dip of 0.70 per cent post-June up to October 7. Similarly, Hindustan Aeronautics Ltd. soared 86.55 per cent pre-June, only to decline by 3.96 per cent afterward. Although a few companies, like NTPC Ltd. and Oil India Ltd.,continued to perform well after June, the general trend indicates a cooling-off across the PSU space. 

"In the stock market, the most important organ is the stomach. It’s not the brain. If you're susceptible to selling everything in a panic, you ought to avoid stocks and mutual funds altogether." - Peter Lynch 

2. Keep Some Powder Dry - Investors who are prepared with cash on hand when the market dips will be able to take advantage of buying opportunities. By holding some cash in reserve, you can purchase quality stocks at lower valuations during a correction. Timing the bottom is difficult, but entering the market after a significant pullback often leads to solid gains going ahead. 

3. Maintain a Long-Term Perspective - It’s easy to get swayed by short-term volatility and panic sell. However, investors who stay focused on their long-term goals are often the ones who emerge successful. Historically, equities have been one of the best-performing asset classes over the long term. Riding through the storm of a market correction and holding on to quality stocks will often yield handsome returns. 

Tactical Decisions for Sector Allocations - Corrections also present an opportunity to rethink sector allocations. Sector rotation—the movement of capital between sectors as the economy moves through different phases—becomes particularly important during volatile times. In the last few months we are witnessing banks taking a backseat and IT and pharmaceuticals taking the lead. 

Defensive Plays: FMCG, Pharmaceuticals and IT - When the market enters a corrective phase, defensive sectors such as FMCG, pharmaceuticals, and IT tend to hold up better. These sectors offer steady earnings even during periods of economic uncertainty and tend to bounce back faster when the broader market recovers. 

Manufacturing and Capital Goods: Selective Opportunities - Within the manufacturing and capital goods space, selective opportunities exist. Power and infrastructure companies continue to benefit from government spending and long-term growth trends. However, you should be selective and focus on companies with strong balance-sheets and the ability to withstand short-term disruptions. 

Consumer Services: A Structural Tailwind - As India’s per capita income rises, there is a noticeable shift in consumption patterns—from products to services. The consumer services sector, including hospitality, retail and entertainment, is likely to experience strong tailwinds as more middle-class families begin to spend on experiences rather than just goods. 

Identifying Market Excesses and Inefficiencies - In every market, there are pockets of excesses and inefficiencies. During periods of euphoria, certain sectors or stocks often become overvalued. Currently, there is a growing concern about the valuation of new-age tech companies, many of which are trading at high multiples despite not generating cash flows. On the flip side, there are areas where inefficiencies remain, particularly in traditional sectors such as manufacturing and metals, where companies continue to trade at low valuations despite strong earnings growth. Investors should focus on identifying such opportunities, where the market has not fully priced in the potential for growth. 

The Bottom-Line: Don’t Panic, Stay Disciplined - Corrections are inevitable. They are part and parcel of the equity market. What differentiates successful investors from the rest is how they navigate these periods of volatility. By staying disciplined, maintaining a long-term perspective, and using market dips as opportunities rather than threats, investors can position themselves to achieve superior returns over time. In conclusion, while the recent correction may seem severe, history shows that markets recover, often stronger than before. 

By embracing a balanced approach, keeping some cash ready for dips, and staying focused on long-term goals, investors can not only survive corrections but thrive in the aftermath. The next few weeks, however, could be trying for the markets as they look forward to the September 2024 (Q2FY25) earnings season and the monetary policy of the Reserve Bank of India. At the global level, the outcome of the U.S. presidential polls will be a key monitorable, besides the crude oil price trajectory.

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