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Correction Time ?

Stocks are rarely close to their intrinsic value. If you invest when prices are below valuation, there is a safety cushion. However investors tend to be fully invested at market tops and under-invested at bottoms

Stocks go up; they go down; they are rarely close to intrinsic value. If you can invest when prices are below valuation, there is a cushion of safety built in. In theory, every experienced investor knows this. However, to buy, you need cash or cash-equivalent assets. And this is where most investors mismanage things. Most tend to be fully-invested at market tops and under-invested at bottoms.

This leads back to the tricky question of timing. If you know it's a top, you know what to do. But you never know for certain that it is a top. If you exit early, you may be forced to sit out and watch prices soar. If you exit late, notional profits evaporate.

Equity fund managers suffer from a scaled-up version of the same problem. At one level, a fund manager is a mega-investor. At another level, he has a mandate, which compels him to keep a certain minimum proportion invested in equity (assuming he is managing an equity fund). At a third level, he has to manage redemption pressures, which increase when prices are low (assuming that it's an open-ended scheme).

Despite these complications, a fund manager, and by extension, the class of fund managers, tries to create cash assets when he (they) think the market is close to a top. That way, they can invest more during the corrective periods at lower costs.

When they get it right, equity funds as a class, have significant cash assets to spare when the market corrects. At those times, they can support the market by entering on small drops. As a result of their actions, prices show small corrections and a full-scale bear market doesn't develop.

On the other hand, major corrections tend to occur when the fund managers get it wrong as a class. If they don't possess significant cash assets when a correction occurs, they cannot enter immediately. The market doesn't find support and a major correction occurs before the funds can enter.

This is just a hypothesis. It appears logical but it could be wrong. However, a look at the picture during a few critical market points suggests we are on the right track.

For example, consider the following phases:

In May 2003, the Nifty was hovering close to the 1000-point mark after an extended bear market. At that time, equity funds held over 9 per cent in cash assets. They bought. The market started a recovery.

In April 2004, the market was moving at around 1700 - up about 70 per cent in less than a year. The fund cash position was at 3.71 per cent.

-In May 2004, the Nifty crashed from a high of 1800-plus down to a low of 1300 before recovering to about 1485. The crash itself was triggered by general elections. The cash position shot up to 6.9 per cent suggesting funds sold through the April-May period.
-In April 2006, the fund cash position was down to 1.8 per cent and the market was ruling high at 3,500.
-In May 2006, the market crashed from highs of 3700 down to 2900-3000. The fund cash was still low at 2.14 per cent. The market bottomed at 2600 in June 2006.
If we assume that the pattern makes sense, the funds got it right in May 2003 - they had cash to spare, the market was down and they bought. Their actions contributed substantially to the subsequent rise.

In April-May 2004, they mistimed matters a little. When the crash came, they were somewhat over-invested and forced to sell to meet redemption pressures. In April-May 2006, they were clearly caught on the wrong foot and unable to immediately raise resources to take advantage of the correction.

What's the picture like in July 2007 following the crash on Friday, 27 July? Well, at the end of June 2007, equity funds held only about 1.4 per cent of assets in cash. They were net sellers through July 1-26, 2007 to the tune of Rs 1,773 crore. Add that back to the June cash positions and the cash position rises to about 3 per cent. That may not be enough to meet redemption pressures and support the market.

Of course, funds aren't the only major market participants. FIIs put in far more money - they have bought a net of about Rs 36,000 crore in the last 6 months. We don't know their resources and current attitude to Indian equity. But on the basis of what we do know, a deeper correction may well occur.