Monday’s historic rally was pure euphoria, but it was also very strange, with hardly any buyers or sellers. With the market running up so much and so rapidly, short-sellers have been unable to cover their positions and the result is a squeeze of massive proportions. Much of the action had been taking place in the options market, and call writers have had their fingers badly burnt. For instance, call options with a strike price of 4,000 on the Nifty, which had closed on Friday at Rs40.55, shot up to Rs369.90.
Writers of these options are faced with big losses. Those waiting on the sidelines to get back into the market after the elections were also unable to buy anything, and it is probable that the market will open up very strongly again on Tuesday.
As expected, the market lifted all boats on Monday, but it was the cyclicals that led the charge. The Bombay Stock Exchange’s (BSE) realty index was up 23.45%, with the capital goods index and the Bankex on its heels. Defensives such as consumer goods and healthcare firms were laggards, but the FMCG index, which gained the least, was also up 7.21%.
While optimism about the new government is justified, it seems the glasses through which investors viewed the market on Monday were more than a little rose-tinted. The belief seems to be, as Anagram Research said in a note, that it is “The Beginning of a New Era”. Those hopes may be belied, but in the short term, there’s no gainsaying that the fear of being left out of the rally will prompt buying on dips.
It wasn’t just the stock market that was euphoric. The currency market was equally so, powered by hopes of a revival of foreign fund inflows. Even the bond market celebrated, with the 10-year government bond yield coming down to 6.25%, from Friday’s close of 6.42%. The big hope is that, as brokerage firm Motilal Oswal put it, the “election results would enable the government to focus on growth and development, pursue reforms to attract large foreign capital flows, invest heavily in infrastructure and continue to invest in the rural economy. All of this, in turn, would boost the confidence of the corporate sector to invest and the consumers to spend”.
But should stocks as well as bonds go up together? After all, the stock market will hope for still more government spending. If the government is to do all those things that stock market investors want, where will it get the money, with the fiscal deficit being so stretched? Even if the government goes in for divestment of its stake in public sector firms, that will, at best, fetch Rs10,000 crore or so, not even a day’s auction in the debt markets. It’s too small an amount to do much to the fiscal deficit. Also, as Anubhuti Sahay, economist with Standard Chartered Bank, points out, “The proceeds from sales of stakes in central public sector utilities cannot be directly used to fund the fiscal deficit. Back in 2005, the government established a National Investment Fund in which all disinvestment proceeds were mandated to be parked.”
Perhaps, if foreign direct investment limits for insurance and telecom are raised, funds will flow into the country, which may be one reason for the rupee to rise so rapidly. But, in spite of bond prices rising on Monday, there does seem to be, at least in the short term, a fundamental clash of interests between the bond market and the stock market. That’s because the former will look for a lower fiscal deficit, while the latter would prefer more government spending. Structural reform such as cutting subsidies could very well affect consumer spending.
Points out Nomura economist Sonal Varma: “If the government’s budget deficit remains very large, resulting in the continued increase of bond supply, then issuing MSS (bonds issued under the market stabilization scheme) would be more difficult and the RBI (Reserve Bank of India) would likely have to increase its reliance on CRR (cash reserve ratio, the ratio that defines the amount of money banks need to park with RBI) hikes, to the disadvantage of the banks.”
A. Prasanna, economist with ICICI Securities Ltd, says he thinks the fiscal deficit will remain high this year and that the bond rally is largely the result of improved sentiment and the possibility that the new finance minister may want to lower interest rates.
As Sahay says, “Stimulating demand in a slowing economy without further stretching the yawning fiscal deficit is a tightrope walk.”
For all these reasons, the task ahead of the new government is by no means an easy one. Add to that the possibility of IPOs (initial public offerings) and QIP (qualified institutional placement) issues by cash-strapped firms to take advantage of the improved liquidity in the markets. Perhaps that is why, despite enthusiastically welcoming the election results, Motilal Oswal Securities Ltd says they “expect the base P-E (the share price to earnings per share multiple) to move up to 15x FY10E EPS (estimated earnings per share in 2009-10, and at Sensex levels of 13,500)”. Citigroup says “the market should hold on to gains at the 13,000-13,500 levels over the near term” and Religare Securities says the “market could move to 14,000 in our view in three months’ time”—all levels that the Sensex has already crossed. In other words, as the Citigroup report says, “There remain enough extraneous economic impediments (global economy, capital flows, the slowdown in the domestic economy), and potentially policy ones too” that call for investors to step back and take a cold hard look at the economic environment. What on earth, for instance, can the government do for the information technology (IT) sector that led to the BSE IT index rising 11.39% on Monday, despite an appreciating rupee?
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