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Suresh Krishnamurthy

It is again that time of the year when stock prices go up — this has happened for at least six years. But even as the November Effect begins to take hold, investors, especially those targeting mid-caps, need not rush headlong into stocks. Stock selection is critical, always.

IN THE first week of this month, the Sensex was up nearly 4 per cent, signalling the onset of the November Effect. November Effect is the phenomenon of rising stock prices between end-October and end-February. If the effect persists this year, too, then the Sensex could be touching at least 6,300 by end February. Enticing indeed!

Yet, investors need to exercise caution. For, the November Effect is as much a cause for concern as it is an opportunity. It is very likely that in a liquidity-induced rally, the cost of acquisition is inflated vis-à-vis the fundamentals of a company. This could reduce returns substantially for the long-term investor. Besides, a strong November Effect has been a precursor to a poor showing, after February. These factors are especially important for investors in mid-cap stocks. So ride the market high, but do not forget to strap on the parachute.

Persisting November Effect

Since 1998, not a year has passed without a November-February rally. Including 2003, the November Effect has lasted six seasons, bringing gains to traders.

The lowest gain recorded during the period was in 2002 when the Sensex rose a mere 11.3 per cent. The highest gain came in 1999, at the height of the IT stock bubble, when Sensex rose 22.6 per cent. For this season, even the low gain, of 11 per cent, would catapult the Sensex to the 6,300 level by end February, when the Budget for 2005-06 would be presented.

Valuation has been no constraint either. In 1999 and 2000, the price-to-earnings multiple (PEM) of the Sensex was about 20. In 2003, it was 16.3; yet, stock prices rose. Now, the PEM is about 17.3. Importantly, the profit growth expectation is probably better than ever. The dividend yield at about 2 per cent is also as high it has ever been at the end of October.

Thus, all portents, except for the oil price rise, signal a rally. If the predictions of oil prices going past $60 before settling at $50-plus for a while come true, there could be pressure on industrial growth and consequently stock prices.

The alternative view is that the November Effect will happen regardless of the high oil prices; if cement and steel companies do not participate those in other sectors — especially IT, banking, healthcare and textiles — will.

There are other positives...

The November Effect will happen for various other reasons too. The outcome of the US Presidential elections has raised expectations of continuity of the US economic policy. This could direct the flow of investment dollars from the US to emerging markets, including India. Any increase in the inflow of dollars by foreign investors has time and again proved the best boost for stock price gains in India.

Industry also appears to be in fine fettle. From early 2003 on there have been signs that industrial activity could get cranked up to higher levels. Through 2003-04, however, industrial growth remained restrained. Since April this year, though, industrial growth has moved to a higher trajectory.

Core operating profits are rising faster. Industrial investment has picked up. Capital-raising plans of corporates appear set to gather momentum. And ahead of such capital mobilisation, stock prices usually rise and remain firm too.

... and risks too

Usually, post-February, there is increased volatility. Stock prices also tend to dip. In 2000 and 2001, prices dropped by about 30 per cent between February and October. They fell in 1998 and 2002 as well. Exceptions were 1999 and 2003 when stocks recorded spectacular gains.

These two years, however, marked the onset of a bull-run. Now, we are waiting for the continuation of a bull run that started in April 2003. So, the period beyond February 2005 could still hold miseries for investors. As always, stock selection is critical to minimise risks.

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