Current market psychology and outlook

As most people in the markets were waiting for the Nifty to fall to 2200 levels it has actually rallied and reached a level of 3500 a whopping 60% higher than the most predicted level at the beginning of March 2009. This has created a scenario today where most fund managers, investors, speculators, hedge fund mangers etc. etc. are a frustrated lot and have largely been left holding lot of cash. In fact a large number of fund mangers used the initial part of the rally of 20% to sell off and increase cash levels. The cash position of Indian Mutual Fund equity funds has reached a level of Rs 18000 crores and there have been significant inflows into insurance companies also. Emerging Market Equity fund have also been seeing inflows to the tune of USD 1 billion per week and FII’s have turned big buyers in the markets over the last few weeks.
This raises the question again and again whether this is just a bear market rally or this is the start of a new bull run. In my view given the fact that economic activity globally seems to have bottomed out and there are clear signs of revival and acceleration in growth in some countries like China and to some extent India stock markets are likely to do well in the medium term.
However I am more concerned on the near term mainly due to the following factors –
–Outstanding position in the Futures and Options segment has now touched a level of nearly Rs 90,000 crores which is nearly double of the level seen at the bottom of the cycle. This size of position in the F&O segment is something of a concern as it is just 15% lower than the peak value we saw in the beginning of 2008 before the markets cracked. However one redeeming feature today is that a large number of Institutions are now taking directional positions in Futures rather than cash, thus inflating this position. Secondly nearly half of this position is in Options rather than single stock futures which had big positions in the beginning of 2008. However speculative activity and movement of stocks based on tips has come back again.
– The markets are totally ignoring a big event risk in India i.e. the elections whose outcome is becoming more and more unclear by the day. Under the circumstances where the outcome of the elections also holds a possibility of the government formation being delayed if the UPA or NDA do not get around 200 seats will be negative both for the economy and the markets in the near term. A large number of infrastructure projects and investment in various government projects can be hampered if decision making gets delayed because of this process. As such it makes sense to let the event pass before committing big amounts to the markets.
–Fund raising through the equity route has started again and unfortunately is being dominated by companies that have severe cash flow problems. The successful issue by one large real estate company is making other companies feel left out and they are thinking if this company was able to raise funds then why not us. This has again led to lot of speculative activity towards stock price movements starting which is aimed towards raising equity funds. Since the cash position in the system is so high and most fund managers are now desperate to deploy that (after a 40% rally) these issues are likely to get good subscriptions. Since stock prices of these companies are at 10-20% of peak prices these are perceived to be cheap. However at the start of a new bull cycle if the new issues are dominated by companies that do not have free cash flows visibility over the next 3-5 years it should be of concern to all of us.
–Bad news is getting totally ignored. As an example given the outlook for the overall Technology sector the stocks of the sector have continued to perform well. There is severe pricing as well as volume pressures for this sector. Moreover for most of the IT outsourcing companies nearly 30-50% of the business comes from Banking and Financial Services companies that are under severe stress. The supporting factor of a continuously depreciating rupee is also unlikely to play out in the current year. The same phenomenon is observed in some other segments of the market like the real estate sector where stocks have been rallying despite weak fundamentals. Although as a market psychology bad news being ignored might be signs of a bull market, however should not be so prevalent at the beginning of a bull cycle.
– As far as the economy goes one fact that is getting ignored is that pre monsoonal rains all over the country have been very poor and the reservoir positions are at multi year lows because of this. On top of this, if the monsoons are below normal it can have an adverse impact on both agriculture growth as well as hydro electric generation. This can have a 0.5% impact on economic growth if things turn for the adverse.

Overall I would say that the long term market outlook and that of the economy has started to look much better than 3 months back but there are some near term concern that can lead to a sharp pull back in the markets in the near Under the circumstances it makes sense for investors to keep on building portfolios in a slow and staggered manner, however leveraged positions should be kept to a minimum as markets will always correct after such strong up moves even if it is a short and sharp correction.

Investors should not get a feeling of being left out as the rally has started just around a month ago and if this is indeed the start of a new bull cycle it will be a multiyear cycle. Be patient, watch the markets and then invest. A 12-15% correction will provide good entry opportunities.