Strategies in a sharp downturn

One problem with the global situation is that the problems could get suddenly and explosively worse, while recovery and improvement will occur only gradually. This is wearing the nerves of investors and analysts.

For example, there could be a sudden collapse in the euro zone and the possibility will remain live for months. But stabilisation will only occur gradually and it would be difficult to diagnose when and if the euro zone was out of the ICU. Similarly, further trouble in West Asia-North Africa could mean the threat of disruption to crude supplies. However, it will take months, maybe years, for the region to stabilise and predictability to return to energy markets.

In such circumstances, assuming no collapse, the market trend will continue to be volatile and uncertain for an extended period. A bullish stance would have to be tempered by the need to wait indefinitely, while accepting that there is a real chance of a sudden collapse and a big downside.

Unfortunately, neither equity nor commodity valuations reflect the possibility of a sharp deterioration. This is probably because it is very difficult to discount an ‘explosive’ downturn, until and unless it actually happens.

Also, nervous investors have parked assets in what they consider the lowest-risk category of hard currency bonds. As a result, the euro, pound and dollar exchange rates and yields don’t reflect the possibility of currency collapse either.

It is difficult to make large long-term commitments under these circumstances to any given asset. The comfort of low valuations doesn’t exist. Nor is there a guarantee of a rapidly improving global macroeconomic condition in the near future.

The classic hedges against currency collapse or a sharp equity downswing are precious metals. But gold and silver have already been bid up to levels where they would be due for big corrections if the global economy recovers. What should a long-term investor do? One possibility is to keep fair exposure to equity. On balance, this is a reasonable strategy. The global environment should improve over a two-year time span and the rupee environment may improve somewhat quicker.

However, it would be prudent to hedge against a sharp downturn. I can think of two possibilities. One, to gamble on the continuation of a dollar uptrend against the rupee with long dollar, short rupee positions. If global conditions worsen, there will be accelerated flight into US treasuries. However, this hedge could backfire if the rupee hardens, on global recovery. The other possibility is to keep long put positions in the March 2012 or June 2012 Nifty at strikes like the 4,500p, or 4,000p. This would mean forgoing 2 per cent of profits if the equity market recovers. But in the event of a further downturn, it would be effective protection.

The author is a technical and equity analyst