The market environment post the US sub-prime meltdown in August has played out pretty much as one had expected. The dollar has come under intense pressure, the Fed has come to the rescue, and there has been a noticeable asset allocation shift towards emerging markets.

The larger, more domestically-oriented markets like India have outperformed massively and investors continue to search for assets/markets with limited exposure to the developed world.

The surprise of course has been in the speed of these moves. While one thought all this would happen with a time lag of at least three to six months, the market began reflecting these changes immediately.

The question of course is as to what one should do now.

I feel that one should now approach the markets with more caution. We have had a very good run from mid-August onwards and the time to temper risk, at least for the short term, may have arrived.

The US economy is clearly rapidly slowing and all the risks are to the downside. The chances of a recession in the US are at least 40 per cent and rising. Consumer confidence there has dropped alarmingly, oil prices at near $100 per barrel have got to hurt and the housing meltdown shows no signs of stabilising.

In addition to all the above, the credit market turmoil seems to be nowhere near the end, as on a daily basis one financial institution after another seems to be announcing larger losses than initially anticipated, with potentially larger markdowns still to come.

There is also a growing feeling that the credit market dislocations will impact economic growth more and for longer than initially anticipated. Bernanke has clearly signalled at the last Fed meeting, that given a choice he is not keen on going down the road of continued and aggressive monetary policy easing and is aware of the long-term inflationary consequences of such a path.

Independent of the weakness in financial sector earnings, some of the large bellwether US companies have reported weaker earnings than expected, denting the strong earnings and margin story of corporate America.

While investors everywhere have bought into the global decoupling thesis, one should not be surprised to see conviction on this score being tested as the US really starts reporting poor economic growth. Investors are likely to get jittery, at least temporarily as to whether emerging markets can truly economically decouple from the OECD countries.

The total cratering of the dollar also has to have longer-term investment implications. While positive for international markets and fund flows into the EM asset class, at some stage can this not restrict the flexibility of the Fed in continuing to drop rates? The one total disaster scenario for global markets has always been if investors lose confidence in dollar-based assets.

If that were to happen, then a forced debt unwinding would be imposed on the US and a reversal of the buildup in economic imbalances seen over the last decade. Such a loss of confidence will also reduce the flexibility the Fed has to lower rates and generally push interest rates higher than they need to be to attract flows into dollar-based assets.

A reduced funds flow into the US will force consumer retrenchment, as savings will have to rise and consumption drop. While we are not at such a juncture today, the one-way move of the dollar has to cause worry at some stage.

As any study on market behaviour post the commencement of a Fed easing cycle will indicate, markets do well provided the US does not go into a recession. If the US were to slip into a recession, then all bets are off and market performance will most likely be weak.

Flows into emerging markets have also been very strong and exaggerated. Take India as an example, wherein net flows have already far outstripped previous records and have come from all corners of the world and from all types of investors.

Such huge inflows have to indicate that many investors are hiding in the EM asset class in search of performance, and will most probably bolt at the first signs of trouble or risk aversion.

China is also in the midst of a bubble that can only end badly, the timing of which is of course unknown. The Chinese authorities seem to be getting more and more desperate to rein in their bull market; at some stage they will succeed.

What will be the impact on the EM asset class of a slowing down of the price momentum in Chinese asset markets?

The market in India is also troublesome, as it has been a very mega-cap, liquidity-driven rally, and very focused on certain domestically-oriented and infrastructure sectors. It has been a price momentum-driven market, and the extreme divergence in price performance has been feeding on itself.

The relative return investor universe (still the bulk of the money in India) is getting squeezed into chasing the price momentum stocks and sectors, as they try to catch up to an index moving consistently higher on narrower and narrower breadth.

The invention of new valuation methods to justify current prices is also worrying, the obsession with embedded value and the willingness to give huge valuations to what are in effect business plans are something which need to be watched.

The new rules on P-notes and FIIs will also restrict flows into India, albeit only temporarily. To the extent investors are reluctant to sell in order to hoard their existing P-note capacity, we are creating an artificial and shallow market environment.

My own sense is that investors are less hedged and more fully invested than they would ideally like to be.

The one thing holding India up is the earnings trajectory of the companies, which has remained extremely strong. As long as this holds, India will continue to outperform at least on a relative basis.

While I am not questioning the longer-term thesis of emerging markets being the new darlings of this global liquidity cycle and being the biggest beneficiary of any liquidity injections, from a tactical perspective the markets may need to take a breather.

Also the move of asset allocations away from the US towards the EM asset class is still very much under way and work in progress, and thus flows into markets like India will continue structurally for years to come. There is no real dent to the long-term thesis, but short-term one should be aware of the risks.