The past five months have seen an extended rally. This uptrend which drove the broad market up 30 per cent had one unusual feature. The entire move came despite a consistently bearish domestic attitude. Rallies of this magnitude generally occur when both sets of foreign institutional investors (FIIs) and domestic institutional investors (DIIs) are net buyers. But since May 2010, when the Nifty hit its last major low of 4,784, DIIs have sold a net Rs 34,270 crore (as of October 27). Despite this, the Nifty rose to a recent high of 6,284 on net FII buying of Rs 49,439 crore. By inference, domestic retail players have also been sellers of Rs 15,169 crore.
The trend and the quanta of cash deployed makes it evident that the entire rally was driven by FII action. There are always differences of opinion about equity values. But attitudes are rarely divided on such clear lines.
It's easy to suggest that for some fundamental reason, DIIs are not comfortable about current equity values. In fact, they have been net sellers since 5,300-5,400 levels. Quite a few domestic funds are holding large amounts of cash.
However, institutional buying and selling is only partly driven by fundamental perceptions. Another influential variable is available corpus. DII corpus is funded by inflows from domestic corporate and domestic retail investors. Substantial retail selling suggests that these inflows may not have been too strong. There also seems to be some fear of further redemptions. This may have made DIIs more amenable to selling into the rally.
In contrast, FIIs have surplus cash and India in particular and emerging markets in general, look attractive due to comparatively higher growth than the First World. The USD inflows have pushed the dollar down 5 per cent versus the rupee since June and forex reserves have risen above $296bn with over $13 billion added in the July-Sept 2010 quarter.
What lieas ahead?
What happens in the second half of this fiscal? The rally may, of course, continue. In that case equity valuations would be increasingly stretched. Another plausible scenario is that domestic players will manage to absorb moderate amounts of profit-booking by FIIs. If this happens slowly, the market will correct downwards in orderly fashion.
The dangerous scenario is that FII money could flow out just as quickly as it flowed in. If FII selling comes at a high pace, the momentum will switch too abruptly for domestic players to counter-balance in a normal way.
In this scenario, the market will sink like a stone until it hits the levels where DIIs consider valuations reasonable. As mentioned above, this could be in the 5,300 Nifty range since DIIs have been sellers from those levels. In a scenario of FII selling, the rupee-dollar equation would also reverse, with the domestic currency weakening, though it would be difficult to predict currency levels with the Euro, Yen, etc, also in the picture.
Here are some things a long-term investor might do to get a sense of direction. One is watch the weekly log of DII and FII trading patterns. Second, watch the dollar-rupee trade levels carefully and also monitor forex reserves position. These numbers are directly linked to FII attitude and a drop in the rupee coupled with a fall in reserves would reinforce indications of a correction.
If a correction starts, one hedge would be buying USDINR futures contracts to try and ride likely USD strength. The extremely high leverage available in currency futures (roughly 50:1) could make even a relatively small position quite lucrative.
Given current valuations, it also makes sense to consider a strategy of weighted rather than equated investment. The Nifty is at a PE of near 25 and it very rarely pays to make broad investments at anywhere above PE 20.
If you're using SIPs to buy widely diversified equity funds, don't reduce commitments. But be prepared to increase commitments if the market falls significantly. This would accentuate the standard logic of averaging down.
In the current fluid scenario, my instincts suggest that it may be more important to watch valuation levels rather than prices. PE ratios are mean-reverting. Prices are not. Prices might not fall all that much. But if earnings rise, PE ratios would fall anyhow.
There are no guarantees when investing in equity. But the probability of a correction appears to be quite high. If it does occur, tweaking a purely passive strategy might improve eventual returns. The currency hedge appears to be marked due to the unusual nature of the rally. Buying in larger quantities at lower levels appears to be common sense.
This article was originally published on December 03, 2010.
Ask Value Research 
New episodes every Friday 
New Process Alert 
Seems like you've uploaded a wrong QR code. Please upload the QR code downloaded from MF Central platform.
