Cold logic says downturn in the markets isn't over yet

The market has reacted with a sense of disbelief as the Sensex fell 11% last week. This is true of any market which has seen long periods of singular directional moves (on the way up or on the way down).This is the reason why investors are at 0% weight in equities at Sensex levels of 3000 and 100% weight in equities at Sensex levels of 12,000.
At 3000 Sensex, when the market started moving up, there was a sense of disbelief that the rise can sustain for a period of time.
At 12000 Sensex there is a sense of disbelief that the Sensex can fall. That is the nature of the market and smart investors who understand the markets do invest at 3000 and sell at 12000. However, there are very few smart investors, and that is the reason why the market gives opportunities for smart investors to make money. The Sensex’s current fall from peak levels of 12,600 to 10,900 in a matter of 10 days has prompted comments like “the market will go up again”, “nothing wrong with the economy but the fall is in line with global trends”, “the government will not let the market fall”, “Foreign institutional investors will not pull out of the country as they have nowhere to go” and “corporate performance is healthy and they will continue to perform well”.

These are typical bull market statements and these statements will keep on appearing until the Sensex falls another 25%.Ignoring such statements and looking at cold logic, the Sensex looks to be headed for longer period of downtrend. Let’s look at the cold logic.

1. Foreign institutional investors (FIIs) led the Sensex rally from 3000 to 12000 levels by bringing in over $40 billion of portfolio money. They have yet to take profits from the rally in Indian stocks. The chances of FIIs wanting to take profits are more as rising interest rates globally has increased risk premium on equities, valuations of Indian markets have gone up considerably with one year forward price-earnings of the Sensex going up from 12x to 20x and political risk increasing as the strong Left party opposes reforms and talk about anti FII measures.
2. Domestic demand was the main driver of the Indian economy, taking GDP growth up to 8% and above in the last three years. The demand was driven by excess liquidity in the system brought about by capital flows from abroad leading to current account surpluses. This excess liquidity found its way to the hands of under leveraged consumers who availed of cheap loans to buy cars, property and services. Now, the conditions for fuelling domestic demand has reversed with liquidity drying up as the economy went into current account deficit, loans becoming expensive as interest costs have gone up, asset prices have increased leading to higher leverage for the consumer and the consumer from being under leveraged is now over leveraged.
3. The market usually discounts future earnings. The future earnings is a forecast and by its nature is not a stable figure. Now, when there is a threat to downward revision of future earnings (from interest rates, inflation, high oil and commodity prices, political stability, reforms, asset price bubbles etc) the market tend to react downwards.

However, in bull runs, the market tends to ignore threats to future earnings and veer towards over-optimism. This goes on till the market reaches heights where it is no longer stable and the fall subsequently is dramatic and quick.
The Sensex reached the stage of instability at 12,600 levels and hence the dramatic and quick fall.The three factors mentioned above have irrefutable logic. The market has to counter the logic to continue its bull run. Conditions can and do change quickly and the threats mentioned above can vanish as quickly as they came in. However, unless one sees signs of the threats vanishing, one should play the market on the sell side.