The Hindu Business Line : Making sense of the Sensex

A NATION-WIDE industrial strike leading to a substantial loss of production, lacklustre performance by most emerging markets, the oil price above $66 per barrel, SEBI banning some Kolkata-based brokers for their involvement in the circular trading... Yet, both the Sensex and Nifty are on a high. Further, the decline in the mid-cap and small-cap indices vis-à-vis a soaring Sensex seems to suggest a schizophrenic existence of a dual economy. These are not the only aberrations that puzzle the financial economist in the country. In fact, the stock market appears to have long stopped reacting to many negative events such as the worst flood in Mumbai, or soaring oil prices due to hurricanes Katrina and Rita.

All these events and developments in the stock market seem to violate the basic premise of an efficient market. Though many financial economists seem to agree that the recent surge in the stock market reflects the strong fundamentals and the fact that Foreign Institutional Investors are finding it increasingly attractive to invest in emerging economies, including India, they remain extremely sceptic about the pace at which the market is growing.

There is a strong suggestion that the recent phenomenal growth in stock prices may not truly reflect the reality and may be contaminated by circular trading. The ban of Kolkata-based traders could probably be an early warning of this deeper malaise.

However, the vexing question is what lessons have we learnt from the scams of the past? Where there is a continuous exposé of the penny stocks by media, the sluggish response of the regulator raises serious questions.

Though the Securities and Exchange Board of India continues to warn small investors to make informed investment, it must do ore to educate the investors. A few small steps such as checking the balance-sheets of the company for last three years; enquiring how many times the company has changed its name in the last year, or at least making a phone call to their offices to check the existence of the company before investing can save quite a few investors. SEBI should also guide first time investors to take the mutual fund route, and expose them to the concept of profit booking. It must also urge them to take a longer-term view of the market rather than trying to beat it in the short-term. Most important,

SEBI must become even more pro-active in detecting any emerging aberration. It is imperative that SEBI becomes scientific in its approach by developing a sophisticated predictive model for insider trading on the lines of the fraud detection model in the credit card industry. Finally, to curb the aggressive speculative activities, the gapping holes in the market microstructure, underlying both the cash and the derivative segments, must be plugged. Like many developed countries, we should gradually phase out cash settlements, slow day trading by ownership transfers and develop a network of market makers who would rationalise the price by providing two-way quotes.

However, we must also recognise that the speculators are the life-blood of the market and that speculation is the process by which price discovery happens. Therefore, investors should be ready to accept certain amount of volatility in the market and also recognise the fact that in a nearly efficient milieu, it is virtually impossible to beat the market all the time. Nevertheless, it is also the role of the market regulator to differentiate the healthy price-discovering speculation from the aggressive manipulating activities and develop a mechanism for early detection of aberration and penalising the manipulators. For now, how SEBI performs this balancing act without hurting the market sentiment too much is worth watching.

(The author is Associate Professor with the Madras School of Economics, Chennai.)

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