The crash of 2006: The beginning of the end or just a blip?

After the sharp decline in May 2004 our stock markets have surged relentlessly except for a brief correction in October 2005. Every modest correction was met with renewed buying and the indices went past their earlier highs with considerable ease.

This had become such a regular feature that every decline was seen as an opportunity to buy. In the post 2006-budget rally of the last couple of months, corrections had become deeper. But the indices bounced back within a couple of sessions, sometimes the very next day.

The current corrective phase has been so severe that it has shaken the conviction of traders and short-term investors. Frontline indices have lost more than 10 per cent within six trading sessions. A sharp pull back rally on Wednesday was followed by an even more severe fall the next day.

Retail investors are clearly confused as most of them tend to panic when markets correct sharply. Memories of pervious declines leading to prolonged weakness have not yet faded. Is it any different this time or is history about to repeat itself?

Triple whammy
The correction started last Thursday after the Left parties performed remarkably well in the state elections; concerns about aggressive opposition from them to the reform moves unnerved the markets. These concerns were aggravated by strong remarks by the spokesmen of the Left Front against the government's move to raise fuel prices.

The second trigger was an aggressive move by the government to reign in rising cement prices. The commerce minister held a meeting with cement manufacturers and gave them a veiled ultimatum to voluntarily cut prices. Cement stocks, which had outperformed the markets in recent months, were among the biggest losers last Friday.

Reports about the government considering stiff controls on sugar stocks to bring down prices led to a decline in sugar stocks. Though sugar stocks are not part of the large-cap indices, they are among the favourites of traders and retail investors.

All these factors were not enough to cause any significant correction in the markets. It required an external trigger in the form of a massive correction in international commodity prices on Monday. The Sensex and Nifty gave up around 4 per cent each as oil and metal stocks came down with a thud.

Indian stock markets are considerably dependent on commodity prices. Oil and metal stocks have significant weight on the frontline indices and any large variation in international commodity prices would have a corresponding impact on the indices.

Short-lived recovery and the bigger fall
Tuesday morning, the indices tanked again as global cues remained weak. But recovery in afternoon trades was highly dramatic and surprised almost everyone. The Sensex surged more than 500 points from its intra-day low and managed to close with gains.

On Wednesday Asian markets recovered, which helped our markets also to bounce back strongly. The previous four painful sessions were quickly forgotten as frontline stocks regained much of the lost ground. Majority of analysts were predicting further upsides in the short-term.

All these predictions turned futile as the US markets tumbled on Wednesday, which led to a sell-off across Asia on Thursday. Indian indices were worse off as they gave up more than 4 per cent in opening trades.

The indices might have managed to hold on to those levels or could even have recovered modestly in afternoon trades, if there were no further negative news flows or rumours. Most traders would have been thinking on similar lines and most probably would have built long positions early in the morning.

Speculative reports that FII's would be treated as traders and taxed at a higher rate had appeared in some newspapers. They had based this story on a CBDT move to separate traders from investors and bring traders under a higher tax rate.

Typical of a government document, the CBDT circular left enough gaps for the media to put out speculative reports. This was the proverbial last straw on the back for the markets, already buffeted by various other factors.

Sharp declines bring margin pressures to most traders who have leveraged positions. A significant part of their trading margins are met by pledging shares held by them. When the indices fall, margin requirements rise while at the same time the value of shares kept aside as margin decline. If the traders are unable to bring in additional cash, the financier or the broker sell the shares kept as margin - accentuating the market decline.

The sell-off seen on Thursday afternoon was reminiscent of the Black Monday crash in May 2004 as large-cap stocks tumbled like ninepins. The indices ended with losses of nearly 7 per cent each, making the Indian markets yesterday's worst performer globally.

FII's follow global trends and press sales
Net inflows from FII's in the cash segment for the first eight trading sessions during the current month, before the volatility started, was a very healthy Rs3,767 crore. But last Thursday, when the correction started, they were net sellers to the tune of Rs1,199 crore.

FII's did not press further sales on Friday, even as the indices declined further, and ended the day with net purchases of Rs18.6 crore in the cash segment.

On Monday, when the indices had one of their worst falls in the last two years, they resumed selling and net sales for the day stood at Rs728 crore. They made further sales to the extent of Rs533.4 crore on Tuesday.

It was surprising that the Sensex recovered more than 500 points from its intra-day low on Tuesday when the FII's made net sales of more than $118 million in the cash market.

FII activity in the cash segment on Wednesday, when the Sensex galloped 344 points, was even more curious. They were net sellers to the extent of Rs424 crore! On Thursday, when the markets cracked again, FII's were sellers to the extent of Rs865 crore.

But FII activity in the futures segment throughout this volatile period is a slightly different story. Last Thursday, when they first started selling in the cash market, FII's made net sales of Rs810 crore in stock futures and Rs67 crore in index futures.

On Friday, their mood turned more bearish as they made net sales of Rs1,017 crore in index futures and Rs110 crore in stock futures. On Monday, the day indices cracked, they made net sales of Rs1,430 crore in index futures but were net buyers to the extent of Rs149 crore in stock futures. No wonder the indices tanked that day.

On Tuesday, when the markets staged the remarkable intra-day recovery, one would have expected heavy buying in index futures by FII's. Surprisingly, they remained net sellers in index futures at Rs49 crore but bought stock futures to the extent of Rs954 crore.

As the markets bounced back on Wednesday, foreign investors made net purchases in index futures to the extent of Rs522 crore and Rs33 crore in stock futures.

Domestic MF's keep faith
Except for modest net sales of Rs68 crore in the cash market last Thursday, domestic mutual funds have been net buyers throughout this period. They made net purchases of Rs356 crore on Friday.

On the day the markets fell the most, domestic MF's were buyers to the extent of Rs785 crore. The next day, they made net purchases of Rs334 crore. Domestic funds continued buying when the markets bounced back on Wednesday and ended the day with net purchases of Rs193 crore.

Continued buying by domestic funds is understandable as some of the larger fund houses still have part of the funds raised in recent NFO's to be invested. Besides, domestic funds are generally less influenced by global factors than overseas funds.

Emerging markets
Most emerging market indices have lost heavily over the last week after the rate hike by US Fed. If US rates keep going up, which is the slowly emerging consensus view, emerging markets would lose some of their attractiveness. Risk adjusted returns from investing in emerging markets would not be attractive enough when compared to returns from US domestic securities.

The decline of the US dollar in recent weeks would have some impact on emerging economies, which are dependent on exports. Their exports would become less competitive, which may lead to a slowdown in growth rates. If the US dollar slides further, which is highly probable given the precarious US current account situation, their export prospects would turn bleaker.

The only stock market, which withstood this global downtrend, was Shanghai in Mainland China. The Shanghai composite index has added over 10 per cent over the last week, even after the correction in the last couple of days. This spectacular run was mostly because of increased overseas fund flows into Chinese stocks on expectation that the Chinese government would allow the currency to appreciate further.

The Chinese Yuan breached the psychologically important mark of ¥8 to a US dollar last week, signalling increased willingness on the part of Chinese authorities to yield to US pressure on currency revaluation. The Shanghai index had remained subdued for the last few years, despite stellar economic growth, when emerging market indices across the globe surged.

Most emerging markets bounced back on Wednesday as commodity prices recovered. They slumped yet again on Thursday following the sell-off in US and another fall in commodity prices.

Has anything changed fundamentally?
Our markets have been rallying on various factors like strong economic growth, benign interest rates and liquidity flows, etc. Analysts are slowly becoming less convinced about some of these factors.

The first factor is global interest rates. The US Fed was widely expected to take a pause from seven consecutive interest rate hikes taking short-term rates to 5 per cent per annum earlier this month. However, economic growth rates in the US is not slowing fast enough while inflation is showing signs of inching higher.

If the Fed continues to hike rates, other central banks are likely to follow suit. Rising interest rates may cool down global growth rates and make equities less attractive for investors. Higher rates may also squeeze liquidity flows into equities.

Oil prices have gone up substantially and would impact price levels, forcing central bankers to keep raising interest rates. A bigger impact of higher fuel prices would be a slow down in consumer spending, which would pull down growth rates further.

Prices of other commodities like metals have also gone up significantly, exerting further pressure on inflation and economic growth.

However, the impact of all these factors on global economic growth may not be as bad as feared. Though most major economies like US and China — which have been expanding at a fast pace — may see a modest slowdown, but are unlikely to see a slump. Besides, other large economies like Japan and EU may compensate for the any slack in the US and China.

Outlook for the Indian economy is much more positive, at least for the next couple of years. Barring a disastrous monsoon, there are no other factors, which could pull down growth rates significantly below the current rates. Even if interest rates go up modestly, it may not have much of an impact on corporate profitability.

Having said that, equity indices are less likely to see a sustained rally this year. In line with global equity markets, the domestic markets are also likely to take a couple of months to settle down after the ongoing correction. Even if they start a fresh up trend, the indices would struggle to go past their highs recorded earlier this month.

So if you are an investor with a longer-term view, stay invested and use such sharp corrections to make fresh purchases selectively. If you are a trader, accept the fact that days of easy pickings are over and prepare for a highly volatile environment.