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Be prepared to exit in a hurry

Markets can stay irrational longer than any person can stay solvent

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Are investors rational? Then prices should behave rationally in the long term, moving broadly in synch with fundamentals. In practice of course, there are long periods when prices are out of synch.

One possible explanation for long-term irrationality in price movements is that investors are looking at the future rather than the present. But many behavioural studies also suggest that investors are not very rational in reality. Even highly sophisticated institutional investors can be irrational and display biases as bubbles illustrate.

When price movements across the past year are compared to the fundamental trends, they seem irrational on the face of it. First, India has seen high interest rates through this period. Second, has stayed flat, or fallen through the past several quarters. Third, have flattened, or fallen, during this period. Fourth, borrowers are struggling to service debt while lenders are seeing and debt-restructuring requests. Fifth, government finances are in bad shape with a high fisc and record external deficits.

Against this backdrop, equity has given stunning returns. The Nifty is up nearly 25 per cent per cent from December 2011 to December 2012. The Junior is up 44 per cent. The Midcaps are up 32 per cent. The is up 50 per cent. Many other sectors have done well. For example, is up 48 per cent, Realty is up 47 per cent, automobiles are up 40 per cent, Pharma up 31 per cent, etc.

What is more, the bull run has been driven by – the most evolved and sophisticated of investor subsets. Overseas portfolio investors have pumped over Rs 121,000 crore into Indian equities. They've also bought Rs 55,000 crore of debt. This quanta of cash spread across equity and debt implies a fair amount of confidence in the economy.

Domestic investors have been consistently negative on equity. Domestic institutions (DIs) have sold over Rs 20,000 crore in equity though they've bought over Rs 5,00,000 crore in debt. Individual Indian investors have also sold equity and cut back on equity mutual holdings as well. Household investment data suggests gold and fixed deposits have been preferred spots.

Forex inflows from FIIs have kept the rupee from tumbling. The rupee has indeed dropped to new lows versus all hard currencies except the Yen. But it has done better than expected in the face of huge trade and current account deficits.

In the short-term, the quanta of FII inflows has guaranteed an uptrend in equity prices. But if the FIIs are rational, what are they betting on, and how likely are they to be correct? India is not a safe haven. It is a relatively fast-growth economy. But the currency risk is large and a sovereign downgrade could happen if the deficits get a little worse.

There have to be positive expectations to offset those risks. The most plausible are as follows. One is that Indian growth will bounce across the next four or five quarters with a marked rise in corporate earnings. Rate cuts will help matters along. And, there may be some dramatic policy action before the next polls.

Rate cuts are not unlikely. The DIs also have massive bets riding on rate cuts beginning with the next RBI policy review since they've upped the pace of subscribing to debt. This possibility has already been discounted in many earnings projections for 2012-13 and 2013-14. Rate cuts would be required to justify current PE discounts and to help sales and earnings expansions in frontline stocks. The direction of policy action is a question-mark. Historically, election year policy action has tended to put more pressure on corporate finances and led to bigger deficits.

The problem with dependence on portfolio inflows is that FIIs can exit at great speed, if they think they are being pursued by the bear. So while the market may trend up for an indefinite period, it could also see a sudden, violent correction.

Sudden pull outs are even more likely if there is some truth to the popular conspiracy theory that some of the FII flows is really Indian black money round-tripping back. If so, this black money is being re-introduced into circulation in order to fund elections to the Lok Sabha and various states over the next two years. It will be exit as those events draw closer.

Experienced traders are well aware that markets can stay than any given person can stay solvent. So you have to go with the uptrend while it lasts. But be prepared to exit in a hurry if the FIIs change their mind.

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