Yes, Nifty indeed went on from one milestone to another in the last few months, showing beautiful resilience. But something doesn't seem to work after it scaled its current highest at 18,604.45 on 19th October. 4 red consecutive trading sessions after 19th, and several others that have mostly ended in the red, people have started anticipating a correction, or worse, a market crash.

While there have been classic debates between the bears and the bulls, one is mostly unsure of what caused it and more so, what to expect.

Different opinions exist to explain this and many market participants have taken sides supporting their favourite leaders, too. Here is why this is happening largely:

1) Inflation

Probably the most agreed upon reason by most traders and economists, inflation is argued to be the cause for the current correction. When an expansionary policy is followed by Central Banks and governments for too long, like now due to the Covid crisis, inflation is bound to occur. You'll know soon how.

The US Consumer Price Index (which is the most common measure of inflation in a country) is at a 30-year high level of 6.2% YoY, which has come earlier than expected. This estimate-beating inflation rate of a superpower country like the United States has caused havoc in not only American but other markets as well. Such deep cuts keep the Indian market a cause of concern as such indicators make investors more fearful.

Since the news was out, the volatility index (18.73 on November 10, 2021) has shot up like anything in the last few trading sessions, like is evident in the chart below:

Source: Google Finance

The fiscal and monetary policies of the governments, too, are likely to witness a change to control inflation, given the economy has started to recover. Such changes might hamper investor confidence in the short run.

2) Overvaluation, Capital Outflow, and IPOs

A concern we cannot overlook is the overvaluation of most companies. Many large-cap, as well as mid/small-cap companies, are trading at their all-time highs. The Nifty average PE hasn't come below 25 since last year.

Amidst the recovering economy, companies are reporting huge earning gains and though most of them have just returned to pre-Covid levels, market participants are mistaking many such companies for 'multi baggers' because of eccentric valuations and future projections. These have led to prices soaring like anything, but not backed by fundamentals. Profit booking above 18,500 was much anticipated by seasoned players and the correction is a result of those.

An interesting trend noticed is the capital outflows of $2.9 billion in Oct-21, as NSDL data shows. FPIs are known to invest for a rather shorter term and sensitive news like inflation hikes are well known for turning them into net sellers in relatively volatile emerging markets like India. Rising oil prices, US bond yield degrades and Chinese economic challenges are also responsible to keep them on tenterhooks.

Source: NSDL, India Infoline website

This section remains incomplete without mentioning the latest IPO run. After great marketing and stellar listing gains, many of these newly listed companies have witnessed selling because of relatively loose fundamentals. The internet company valuation bubble is likely getting pricked, many say. Unhappy with returns, many are also growing hostile towards new IPOs now, which may have contributed a bit to the market correction.

How does inflation occur

It is important to understand how inflation occurs to gauge the markets better. Any business or economy moves in cycles, or phases namely expansion, peak, contraction, and troughs. When Covid struck the world, the economies of all countries hit rock bottom, since lockdowns didn't allow any economic activity. We entered a recession, which is a trough in economic terms. Governments announced policies like increasing money supply, improving their public expenditure, lowering interest rates, etc to push economic demand and employment. Markets also picked up.

Since now there is more money available for the same number of goods, the value of a rupee decreased, and the same goods now claim a higher price. This is called inflation.

To curb inflation, the government is likely to increase interest rates and the reverse of policies announced earlier, which makes debt costlier and contracts some amount of economic demand.

Equity markets are an indicator

There exist certain indicators that help us understand which phase of the economic cycle we are headed in. Certain indicators like building permits, wages per hour, consumer preferences and equity markets are leading indicators since they can predict the near future of a cycle.

Equity markets represent investments in business that are likely to drive the economy. Their activities indicate where the economy is headed and investments are made according to the prospects.

Others like employment rate, interest rates, and GDP are lagging indicators, that confirm the stage of the cycle we are in.

What should you do as an investor?

First, be aware of important news like internet rates and inflation indexes that have an effect on markets and the economy at large. Slashed interest rates, as was the case during the annual budget, indicate government targeting expansion and many capital intensive and cyclical sectors are likely to witness good investment and demand. Such include real estate, construction, capital goods such as metals, and consumer discretionary products like auto and electronics since they can now be availed for at a cheaper rate.

When the government hikes interest rates and reduces public spending, which is likely soon, given the inflationary pressures, realize that a contractionary policy is taking place. Since credit and things are getting expensive now, it is advisable to stick to defensive industries that are evergreen. Some of them are food, healthcare, and utilities.

Note: Some sectors like real estate and infrastructure are still being supported, hence their growth hasn't been exhausted yet. Beware of the latest government policies.

In the long term, however, such policies just have a temporary role and don't affect the fundamentals of any company, though they may be catalysts for certain new leaders. Having a well-diversified portfolio with some funds allocated to a mix of currently booming industries promises a good recipe for great aggregate returns.