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Suresh Krishnamurthy

The November effect usually adds 13 per cent to the Sensex between October and February. That has been the case the past five years. If it happens this year too, it could put stock prices out of tune with their fundamentals. Picking stocks with limited downside risk is, thus, important now.

WILL the November effect be felt in stock price movements this year too? The bullishness in recent trading sessions, which has sent Sensex rocketing past the 5,000 mark, suggests that this might well be so.

The rise in stock prices between end-October and the following February is called the November effect. If it materialises this year also, the Sensex will cross the 5,500 mark before the Budget in February 2004.

Given that non-index stocks have had a better time than Sensex stocks, this could catapult non-index stocks even higher. The markets look ripe for an orchestrated rally that could push prices to levels that may appear out of tune with the fundamentals of listed stocks.

While the going might please investors in the short term, careful stock selection is vital to forestall the possibility of future losses.

November effect: The November effect has manifested itself in stock prices in seven of the last ten years. Stock prices rise by about 13 per cent from the level set at the end of October to end-February, when the Budget is presented.

The rationale? A simple reason could be that market forces expect the Government to take measures that will accelerate economic activity. Stock prices rise in anticipation of such improvement.

Importantly, in five consecutive years, starting from October 1998, this effect has been felt in stock prices. Could this year be different? It already is. In the last ten years, the rally prior to October has never been as robust as it has been this year.

On an average, it has been a negative six per cent. So, prices usually rise from November to offset the decline as optimism returns to the market.

However, this year, between end-February and October, stock prices already increased about 50 per cent. The only parallel is 1999, when prices rose 30 per cent between February 1999 and October 1999. Between October 1999 and February 2000, prices rose a further 23 per cent.

This year is different for another reason too. The market has already priced in an upturn in economic activity. It did not have to wait for the Budget to provide the spark. So, with economic activity priced in, why should the market rise further, is a legitimate question.

Nevertheless, the market will rise and become over-heated if liquidity persists. Inflows from FIIs after December will hold the key.

Beyond November effect: However, where the Sensex is headed before February is only a minor statistical detail. Investors are likely to be more concerned with the underlying fundamentals of the economy and whether it can sustain a further robust rise in prices even beyond February 2004.

A few factors need to be considered. As of now, there are only incipient signs of a recovery in investment demand. A few companies are expanding capacities; some are indulging in overseas acquisitions. But there are no larger trends.

Besides, improvement in economic activity is not yet reflected in the index of industrial production or a pick-up in credit off-take. So, expectations of a consistent rise in stock prices over the next few years appear premature.

On the other hand, retail investors are now hard-pressed for attractive investment opportunities.

Some stocks may be attractive even at present levels. If HDFC, Grasim, SBI, BPCL and Reliance can deliver after-tax annual returns of about 8-10 per cent over a long period of 8-10 years from now, investors may still consider them worth investing in. This is because expected after-tax returns from non-equity investments is less than 5 per cent annually.

So, the situation appears ripe for further flow of liquidity in to the market. This could take stock prices higher to an irrational plane. If stock prices do rise further, as in the past five years, investments made in January or February 2004 may not have much potential to deliver extraordinary returns in the short term of one to three years.

In the short term, the investments may even turn out to be loss-making if expectations of economic recovery prove short-lived. As such, selection of stocks in which downside risk is limited is of paramount importance now.

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