Up, up, and away

Friday saw the Sensex and CNX Nifty scale new peaks, a rise of almost 3 per cent in a single day. This has come on the back of a market that has been rising almost steadily since February — buoyed largely by swelling hopes that the general election will throw up a strong NDA government. While it is impossible to predict the verdict (never mind what the opinion polls and the reportedly leaked exit polls say), it seems beyond doubt that there is a touch of irrational exuberance about the recent surge. Small- and mid-cap stocks have risen faster than large-caps over the last few months, there is a huge build-up of positions (long and short) in the futures and options market, and punters have begun playing the penny stocks. Added to this is the presence of a large number of positional traders who are in the game to pocket quick gains from short-term post-election market swings.

The action in the market has been driven almost entirely by foreign institutional investors (FIIs). This raises the natural question: are we going to witness a huge FII sell-off? Also, will this happen only if the verdict is hopelessly fractured? Or, will it happen irrespective of the result, since the surge has been caused by a sizeable influx of ‘hot money’? It is impossible to quantify how much of the $10 billion the FIIs have pumped into the Indian stock market since September 2013 qualifies as hot money. At the same time, there is evidence that hedge funds and event-based arbitrageurs have joined the party. There is a strong correlation between India’s markets and others such as Thailand and Indonesia, where short-term FII money is betting on election outcomes. There has also been a sharp rise in the share of FII investments through Participatory Notes, which are typically used by global hedge funds. (PNs are used by players who do not wish to register in India.)

All this may warrant a note of caution for new investors planning to join the pre-election rally at this late hour. But it doesn’t pose as much a headache for Indian regulators or the exchanges compared with 2004 and 2009. The prospect of small investors burning their fingers in the event of a post-May 16 meltdown is somewhat diminished as retail participation in the rally has been extremely weak. Also, retail holdings in outstanding shares are down to 8 per cent as opposed to 12 per cent five years ago. There is no cause for policymakers, exchanges or SEBI to intervene to control the market should there be an FII exodus. All we need are routine safeguards to ensure the orderly functioning of the markets, so that there is a smooth absorption of a possible spike in volumes and no precipitation of a settlements crisis.

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