"If you have trouble imagining a 20% loss in the stock market, you shouldn't be in stocks."
- John C Bogle, Founder of the Vanguard Group, the world's largest no-load mutual fund group

In stock markets across the world, fear is taking over from greed. Indices are falling hard; bad news seems to be everywhere. In such an environment one cannot be faulted for getting swayed by sentiment and becoming pessimistic about the stock market outlook. But then no one ever made extraordinary returns by doing what every other person is doing.

Consider the one key 'bad' news for stocks that is being spoken of from our perspective - the yen carry trade is expected to unwind (the yen is the Japanese currency).

What is the yen carry trade?
Well, this is how the yen carry trade works (a simple example involving the yen and the Indian stock markets):

As an investor you borrow money in yen, where the overnight rates of interest until recently were 0.25 per cent; before that they were zero per cent (yes, that's true). Effectively, the cost of borrowing this money (i.e. the interest rate) is negligible.

Now that you have the yen, you convert it to Indian rupees at the prevailing exchange rate.

With the Indian rupees you can invest in the Indian stock markets.

Now, the return that you make on this entire transaction will be determined by three factors -

1. The return on your investment in the Indian stock markets (let's say 15 per cent is what you made in a year)

2. The exchange rate at which you will convert the rupees back to yen (for repaying your borrowings). If the Yen becomes a stronger currency vis-�-vis the Indian rupee, then you will get fewer yen for every rupee you own as compared to what you paid when sending money to India; effectively, you will incur a loss. On the other hand, if the Yen weakened, your returns would be enhanced.

3. The interest you have to pay on your yen borrowings

Let's say the exchange rate and the interest rate remains unchanged. In such a scenario, your return will be -

Return earned in the Indian stock markets - 15.00 per cent
Cost of Money - 0.25 per cent
Profit/Loss on exchange rate - NIL
Therefore, net gain - 14.75 per cent (15.00 per cent - 0.25 per cent - NIL)

Come to think of it, this seems to be a brilliant investment strategy. But then, what happens if the interest rates and the exchange rate move against you?

As has happened in the last fortnight, the cost of money has edged up to 0.50 per cent and the yen has appreciated against the Indian rupee by over 6.00 per cent. Suddenly, the return has shrunk to 8.50 per cent from 14.75 per cent. And if you factor in that the outlook favours rising rates and a stronger Japanese currency, you know what will happen to the carry trade - they will unwind. This is presently happening across all emerging markets and also markets like Hong Kong and Singapore.

As these carry trades unwind, stock prices will fall further (as selling pressure increases) and the yen will become even stronger (as demand for yen vis-�-vis other currencies increases). This will further stoke the sell-off; i.e. it possibly can be a downward spiral till such a time that such carry trades are unwound.

This is basically how a simple carry trade works, both when all is good and when it gets unwound. Presently, we are apparently taking a hit as the carry trade is getting unwound. Since there are no official estimates of the quantum of these carry trades it is impossible to tell if and when this unwinding will stop. Also, it is important to note that even after the recent hike in interest rates to 0.50 per cent, money is still very cheap in Japan. Therefore, it is not necessary that all carry trades will be unwound.

The other reason ofcourse that is being spoken about is the slowdown in the US economy that is expected to play out towards the end of the year.

Indeed, this is a negative for the world as its main growth engine slows down (the US is a big net importer of goods). Since India is a part of the global economy, it will be impacted by the slowdown. But the question is whether we will be impacted as much as the other economies?

To understand this lets compare China and India. China is of course from where this entire sell-off in the global markets started. The Chinese economy is dependent to the extent of 40 per cent on exports; private consumption accounts for only 46% of the economy. This makes the Chinese economy very dependent on global growth. The Indian economy on the other hand, is dependent on exports only to the extent of 18 per cent; private consumption is at a strong 67 per cent.

So, we are likely to be hurt a lot less in case of a global slowdown vis-�-vis a country like China. However, in present times, when fear clouds investors' thinking, such facts are overlooked; indeed in present times all emerging markets are falling in-line, precipitously. A look at the numbers and the picture is quite different, country to country.

So, you have the unwinding of the carry trade and a slowdown in the US economy. The first of these reasons will have a short-term impact. The other could have a more sustained impact on the global economy; the impact on India however will be muted as we have seen above.

Among the other factors one needs to watch out for - rising interest rates in India and the consequent slowdown in the economy. Both these factors are expected to have an impact on the overall profitability of the corporate sector. However, our realistic estimate of a 15 per cent year-on-year growth in earnings over the next 3 - 5 years remains unchanged; this (as fundamentals suggest) should ultimately reflect in stock prices. If you are expecting faster growth in corporate profitability and therefore higher returns from the stock market, beware of the risks.

So, where do we think the stock markets are headed?
In the short-term - we are not capacitated to make short-term calls.

From a long-term perspective - given that current valuations are looking attractive from a long-term perspective, returns should be in line with our expectations of a 15 per cent CAGR (compounded annual growth rate) over a 5-year period from a well selected basked of stocks/diversified equity funds.

So, what should you do now?
To realise your long-term goals and objectives, you need to stick to your financial plans. Any investment you make should be in line with the same; do not over/under commit to any particular asset just because the near term returns from the same are good/bad. Always remember, in the long-term, it's the fundamentals that matter. Not the noise.

Happy investing!

Money Simplified - The definitive guide to Human Life Value