The Hindu Business Line : Of Sensex crashes

Recently you may have observed, if you had taken time off from your busy work schedule while Solitaire kept crashing, that the Sensex itself crashed by several hundred points. Apparently this took everyone by surprise. (Not me though).

TV pundits admitted that they had not seen it coming at all. They sounded pretty pained really. A crash usually means that they need to start all over again: study market fundamentals, draw up investment plans, analyse various options.

Now those new managers amongst you who work in the financial sector and whose careers depend on the stock exchange are well aware of the mechanics of the Sensex. They are free to get on with their CV making, kidney selling and mortgaging of ancestral property.

But the rest of you young managers, the non-finance types, need help. You guys base your investments on simple research techniques like "overheard in lift", "recommended by humour columnist" and "Orkut scrap" and seem to not understand even the more basic stock market mechanics. If you fall in this category then this piece is for you.

This fortnight, we will study the phenomenon that is the Sensex crash to understand how the global capital markets are closely linked to each other. We will see what market forces drive peaks and troughs in the market.

Disclaimer: I must state right away that my analysis of stock market crashes may not be entirely correct. While I have made every attempt to check each and every fact in this analysis, some inadvertent errors in the form of typos, spellings, facts and complete paragraphs may have slipped in. Especially in the analysis part.

Therefore, while I care for your welfare deeply I will, in a court of law, disown all responsibility for your complete and utter fiscal destruction.

So, we were talking about Sensex crashes. Now as I write this column, I notice that the Sensex has dropped by another 450 points today. A quick scouring of the news channels reveal that there is popular opinion that this is due to, and I quote, "A major sell-off by funds sparked by a weakening trend on the global markets on concerns over the slowdown in the US economy."

Or, in other words: "Actually, hee hee, we don't know. We pulled that out of our you-know-what. Come on, we have to broadcast for 24 hours you know!"

The sad truth is that no one really knows why the Sensex crashes. But then, I take my duty to guide my readers very seriously. I will go that extra mile. I am a man of my word mostly. So I decided to go behind the scenes and bring you the truth.

First, we need to understand what exactly the Sensex is. A lot of people think they know about the Sensex, but actually don't. For instance, in the course of my research I had this exchange with a rich broker friend:

Sidin: "Dude what's up?"

Broker: "Nothing much. Made a killing on the market. Sensex is up man."

Sidin: "I see. And what is this Sensex exactly?"

Broker: "Err... a wild orchid?"

Sidin: "What the... "

Broker: "Let me buy you dinner at the Taj."

Sidin: "Sure. You are such an intellectually sharp fellow I must say. Ever thought of Mensa? Can we have lobster?"

Now how stupid is that?

In just two days I was able to confirm that the Sensex was not an orchid but, instead, is a value-weighted index of the thirty largest and most actively traded stocks on the Bombay Stock Exchange. The stocks are picked in such a way that all sectors (manufacturing, IT, textile, Sector 17 in Chandigarh and so on) are fairly represented. In addition, the stocks must be able to lose their value so rapidly and without provocation that by the time a humour columnist rushes to the rest room and returns, his portfolio is worth the price of a used croissant.

Now I know what some of you are thinking: "The central tenets of modern portfolio theory supports the use of capitalisation-weighted indices, that is, the optimal strategy for any investor is to hold a market portfolio — the value-weighted portfolio of all market assets. But don't empirical tests show that this may not entirely be the case?"

I encourage you to not think like that ever again. Please, for the love of humanity!

So now what happens when the Sensex crashes is that a large number of the stocks in the index fall in value simultaneously and rapidly. That is, a lot of people decide to sell all their stock all at the same time.

The secret to the crashing Sensex lies in finding out why people do this. So I decided to go out and ask:

Sidin: "So did you sell a lot of stock today?"

Broker: "Oh, every last one."

Sidin: "Why, pray tell, did thou do so?"

Broker: "Saw something on TV. Apparently there has been a meltdown in the Far East markets. I sold everything and booked profits."

Sidin: "What is a meltdown?"

Broker: "Err... a wild orchid?"

This was alarming. No one seemed to know why exactly they were selling their stocks. But as soon as someone else did, they did too. Herd mentality.

So was that it? Is the entire premise of the Sensex based on the blind myopic transactional nature of our brokers and traders? Is there no real strategy behind these multi-crore trades?

That was when I finally got a chance to meet `Pastrami' (not real name). `Pastrami' is one of the biggest names in stock trading in Mumbai. He is what they call a stock market pundit. He is a recluse and refuses to meet anyone if he can help it. So I wrote him a frank and earnest letter.

He was happy to meet me when he read that I was doing this for the betterment of young managers everywhere and, subsequently, that I was a young, single attractive woman called Natasha who was lonely.

When I walked into his office `Pastrami' was on the phone with a TV channel giving an interview. Simultaneously, he was shouting orders across the room to a desk of flunkies. "Short sell everything," he screamed his palm firmly screwed around the mouthpiece. When the time came to speak, he spoke solemnly into the phone to the journalist at the other end: "I expect the market to continue falling. What with all this major sell-off by funds sparked by a weakening trend on the global markets on concerns over the slowdown in the US economy... "

I was aghast. This was clear market manipulation. And it was happening in broad daylight. I walked over to `Pastrami' and asked him in a firm voice: "I have a few thousand rupees to invest. What are you manipulating next?"

And he told me that...

Sorry, hit the word limit.

(The writer, an alumnus of IIM-A, was a management consultant before quitting to work on a book and a full-time writing career)

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