Friday was another bad day for the bulls on the Dalal Street. The NSE Nifty lost another 38 points to close at its lowest level in nearly two months.

The Nifty has now shed nearly 9% in the last two weeks. This may have warmed up the cockles of the bears, but the sudden fall in the market in the aftermath of the credit policy must have come as a shock to retail investors. Most missed the first leg of rally, believing it to be just another relief rally.

Many could not participate in the post election rally either as index hit 10% upper circuit on two consecutive days. So by the time retail investors warmed to the current rally, most stocks had doubled from their lows of 2008.

Thankfully, most portfolios would still be in the green as leading stocks have retreated by no more than 15-20 % from their recent highs. This excludes, telecom stocks which have fallen anywhere between 30-40 % from their highs. So what should retail investors do? Should you book whatever profit is left in your portfolio?

Before we answer the above questions lets try to locate the likely reason for the market fall. The first and the most obvious reason for the fall is that the market had become pricey and was getting ahead of the fundamentals. Consider the first part of the equation, ie, valuation.

Historically, equity markets have a tendency to oscillate around a mean, and for Nifty, that line of oscillation is a price to earnings multiple of around 17. The bulls try to take the market as above this line as possible but beyond a point it gets unsustainable and the market falls to the mean.

At the height of the dotcom boom in 2000 and in late 2007, Niftys was trading at 28x. Bears on the other hand, want it dirtcheap and on occasions have dragged Nifty to incredibly low levels. For instance at the peak of the market meltdown in 2008, Nifty valuation fell to all time low of 10x. However, as the chart shows, the extreme values are always followed by a sharp reversal in markets fortune.

Based on this framework, Nifty had turned unsustainably expensive by the middle of this month. At its recent high Nifty was trading at nearly 23 times its earnings. In the past such a high valuation has always been followed by a deep correction.

So, old timers wont be surprised at the events of last two weeks. In fact going by the historical standards, the correction is mild so far and not enough to pull in quality buyers. The Nifty needs to correct by at least another 10-12% or around 450-500 points, so that its valuation again gets reasonable. In the past, all subsequent rallies have begun from the level of 16-18 x.

This brings us to the second part of the equationcorporate earnings. If profit is strong and sustainable the market can carry on with a high P/E multiple. But the future outlook on India Incs earning growth looks uncertain. Few sectors especially auto and cement did shone in the second quarter, but it largely attributable to the external factors.

There was hardly any hint of a secular demand growth. And given the run-up in food inflation and rise in commodity prices, an inflationary expectation is building-up which will force consumer to cut back on all nondiscretionary spending that will hurt aggregate demand across sectors. Worse still, it will create uncertainty in the mind of consumers and investors.

But you may ask, none of these negative factors are new and were known for months. Why did market fell in the aftermath of the credit policy, which anyway didnt announce any big policy change. The answer lies in the tenor of the policy, which signalled the end of an easy monetary policy and beginning of a monetary tightening.

This means that traders and speculators may not have the surfeit of liquidity at their disposal to bid-up the share prices notwithstanding underlying fundamentals. They also fear that, other central banks may take cue from RBI and end their own easy monetary policy. This may worsen the global cues (read foreign money flows), which had always played a central role on the Indian stock exchanges.

To sum up, the recent fall in the market was long overdue. The credit policy just became an alibi. Rather than mourn it, retail investors should take advantage of the market fall and pick-up goods stocks most of which had become too pricey.