The Hindu Business Line : Return of the beast

Though one may want to dismiss the sharp decline in the Sensex as a long awaited and healthy correction in a market that had run way ahead of corporate fundamentals, it is the right time to look at several factors carefully.

The seemingly improbable happens all the time in financial markets. A year earlier (August 1997), the Dow had fallen by 7.7 per cent in one day (probability: one in 50 billion). In July 2002, the index recorded three steep falls within seven trading days (probability: one in four trillion). And on October 19, 1987, the worst day of trading in at least a century, the index fell 29.2 per cent. The probability of that happening, based on the standard reckoning of financial theorists, was less than one in 10(to the power 50) — odds so small they have no meaning.

Extract from the book The (mis)Behaviour of Markets: A Fractal View of Risk, Ruin, and Reward, by Benoit Mandelbrot and Richard L. Hudson.

Investors in India would have, over the last week, empathised with this quote from the guru of fractal geometry. In seven trading sessions, the BSE Sensex plummeted 1,670 points (or 13 per cent), recorded the largest single-day crash in Indian stock market history, and witnessed the wildest intra-day swings in a long time.

Volatility, that infamous beast, is back, and with a vengeance. Not that we missed it in the past, just that its intensity has had the desired "shock-and-awe" effect on the markets.

Though one may want to quickly dismiss this sharp decline as a long awaited and healthy correction in the market that had run way ahead of corporate fundamentals, it is probably the right time to look at the factors carefully. The market, which had in the recent past managed to ride out of rumours of FII suspension, changes in futures margins and the fears of an IPO scam, has finally succumbed to a confluence of factors:

Global interest rates

The key trigger for the carnage last week is the fear that interest rates are set to rise across the globe and that the impact will be felt in the Indian market (apart from domestic factors: see main story). From a valuation standpoint, rising interest rates are usually a negative for the stock market, as they lead to a change in the risk-free rate used to calculate the cost of capital. The hike in the US federal fund rate to 5 per cent recently, with the Federal Reserve keeping the window open for further rate increases, was the first jolt for the markets.

In the Euro-zone, as companies get into capital investment mode, inflation fears have resurfaced. These jitters were also felt on the FTSE-100, which declined this week as the Bank of England indicated it may raise interest rates. Finally, Japan seems to be climbing out of its deflationary spiral, with the Bank of Japan signalling an upward bias in interest rates.

The effect of interest rate hike in the developed world was felt in the Asian markets, including the BSE, which tumbled across-the-board. As bond yields start to look up, investors will re-evaluate their investments in the coming weeks.

Metals meltdown

As an asset class, commodities (including metals) have had a dream run for the past few years. However, as interest rate fears set in, there was the much-awaited correction. Hedge funds, which had poured money into these commodities, appear to have contributed to panic selling in the metals space. Copper shed nearly 10 per cent, with gold, aluminium and zinc also joining the retreat over the past week. Considering that copper prices have quadrupled in four years and gold has nearly tripled in five years, there were fears that this correction was the just the start of the meltdown.

As leading copper and gold stocks fell globally, domestic stocks such as Hindalco, Sterlite Industries, National Aluminium and Tata Steel moved in tandem with international trends. These were significant losers, declining more than the benchmark indices.

Domestic confusion

Confounding the confusion prevailing in the markets were the CBDT circular on taxing the FIIs and the Left's demand on reintroducing long-term capital gains tax.

A look at the FII data from May 11, when the market started tanking, shows that FIIs have been net sellers to the tune of nearly Rs 3,300 crore. And the markets tanked despite mutual funds stepping in with strong buying to fill the void created by the FIIs.

Liquidity worries

There is no gainsaying the fact that the recent rally was driven by liquidity. The question is whether there will now be a lull in this phenomenon.

On relative valuations, emerging market destinations such as Indonesia, the Philippines, South Korea or Taiwan look attractive, which means that money may start moving towards these markets.

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