Markets are at a high, with relentless rallies over the past year and a half. Retail investors are flocking to the equity market, particularly the riskier segments like small caps. This trend has intensified recently, with funds flowing into thematic and sectoral funds. This isn't surprising; it was an expected outcome of the momentum built in financial markets when central banks worldwide paused interest rate hikes in 2023. I wrote an article in April 2023 explaining how a pause in interest rates would likely boost equity markets. As of today, the S&P 500 is up 22%, and the Nifty50 has surged 38% since the US Fed and RBI paused interest rates, respectively.
In another article from the end of 2023, I had highlighted the peak in price momentum and predicted that equities would continue the bull market rally for the first 2-3 quarters of 2024. Indeed, the market dynamics have been relatively straightforward since 2023, with strong earnings and investor optimism driving the rally. However, experts suggest that 2024 might be a transition period with some volatility, as the Federal Reserve's decisions on interest rates and inflation continue to play a crucial role.
The winds of change have started to gently sweep across the markets. Although prices have yet to reflect any significant shift, price momentum peaking across markets, indicates we are nearing a turnaround. In my article on momentum, I outlined three primary reasons for expecting 2-3 quarters of bullishness: the momentum itself, the impact of a rate pause on businesses, and the lag effects of the 2022 rate hikes. Interest rate hikes do not affect businesses immediately but with a delay. Previous articles, including charts, show that it takes a minimum of 8-16 months for a recession to hit after a rate pause is announced. This means there is a one to one-and-a-half-year lag for the interest rate policy to fully impact the economy and financial markets.
Back in 2022, many people were hesitant to invest due to the rapid interest rate hikes by the Fed. They overlooked the delayed effects of economic policy and missed out on opportunities. Now, as these lag effects have nearly played out, the same investors are experiencing FOMO and jumping into the current peak bull market. This is compounded by new retail investors diving into exotic products like thematic funds, hoping for quick profits without understanding the risks or the products themselves. Unrealistic return expectations are common among market participants, driven by the recent gains of a favorable bull market.
Currently, the three reasons for expecting the bull market have nearly played out. The momentum cycle is very close to peaking. Price momentum is a fascinating data point as it effectively captures market sentiment. It is very close to a cyclical high, and in some segments, it has already peaked. What makes this more compelling is that momentum across multiple timeframes and segments is at its peak. This includes not only weekly and monthly momentum but, in some cases, even quarterly momentum. This trend is observed across market caps (Nifty50, Mid-Caps, Small-Caps), geographies, and asset types like gold. Similarly, US indices such as the S&P 500, Nasdaq, DJIA, and Russell 2000 are all at the top of their monthly momentum cycles.
The synergy of peak price momentum has two effects. Firstly, as long as market participation remains high and uninterrupted, rising prices will attract more investors, which in turn increases prices and their momentum. This creates a positive feedback loop, where momentum across timeframes and markets can lead to a rapid, euphoric, and irrational market rally. Secondly, it sets the stage for a bear market. As investors pull future market returns forward through aggressive buying and chasing returns, it disrupts market dynamics, increasing the likelihood of the market stumbling and collapsing. This was evident when people rushed to buy the dip caused by the general elections, a news-based volatility in June. This is a first-order effect of high price momentum and the FOMO triggered by peak market momentum.
The lag effects of rate hikes are indeed catching up. We are already 16 months past the rate pause, which aligns well with the 8-16 month lag effect previously mentioned. Even if the cycle extends for another quarter or two, we are nearing the end, considering the long-term bull-bear market cycles. So it is evident that there is also a synergy between price momentum and the effects of high interest rates.
The broader market's outperformance compared to large caps (Nifty50) is nearing its end. This is evident from the heightened interest in small and midcap stocks, mutual funds, momentum funds, and thematic funds, with momentum reaching a peak. The relative performance of Nifty500 over Nifty50 is also at a monthly and quarterly high, indicating that the broader market's outperformance over Nifty50 has largely played out. Therefore, the broader market is likely to cede momentum to large caps. When investors chase high returns, they often turn to large-cap stocks as a safe haven when broader markets underperform. This influx of investment accelerates momentum in large caps, allowing them to sustain a bull market longer even after broader markets peak. This explains how momentum can shift from one market segment to another, completing long-term momentum cycles across all segments.
As momentum continues to grow and reaches its peak, the sequence of events that could be expected is as follows:
A positive feedback loop causes more retail investors to over-allocate into equity, sending prices parabolic.
Some event short-circuits this feedback loop and market momentum, such as bad economic data (recession), a bankruptcy due to high interest rates, or a default by a major player in any market (banking, financial, housing, industrial, etc.).
Equity markets either consolidate at higher levels (time correction) to resume the bull market later, or they undergo a price correction.
Predicting which of the two outcomes from the third step will occur is tricky and depends on the severity of the events that disrupt market momentum.
Regardless of the outcome, markets have already moved significantly forward from a bullish outlook since 2023, and a market churn is likely in the coming months and quarters. It is time for investors to review their goals and asset allocation to avoid over-allocating into equity and to follow a disciplined investment plan or strategy.
As parting notes, we investors can be likened to the layers of an onion, with the market (especially during a bear phase) acting as the peeler. The first layer consists of investors doesn't understand equity, cannot afford any loss but still invest in the riskiest categories. When the market peels this layer away, the second layer is revealed: investors who understands equity, but doesn't understand risk, having a short investment horizon of 1-3 years ("I want best returns, Ok with high risk" types). The third layer includes those who claim to be long-term investors but lack understanding of asset allocation and rebalancing, betting entirely on equity. The fourth layer comprises investors who are genuinely in for the long term and follow proper asset allocation but have never experienced a true bear market, relying only on theoretical knowledge. Finally, the fifth layer consists of seasoned investors with a long-term plan, proper asset allocation, and strategy, who have also survived bear markets. With every 10% drop in the index, one layer gets peeled away. Even experienced investors can lose their composure during a cyclical bear market, as the market has a way of challenging preconceived notions and teaching new lessons. Let's wait & see what the great peeler has to offer us.
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