Are markets becoming complacent?

Conviction is admirable, but complacency is detrimental. In the recent past, the markets have migrated from conviction to complacency. While the former gives one an edge, the latter is destructive. No doubt, this flight has been largely powered by the recent stupendous fund flow into the market. I believe the risk perception of Indian equities is depleting which is reflected in the market’s sentiment indicator.

The futures open interest has catapulted to Rs 68,200 crore ($14 billion), which is above the January 2008 (Rs 52,000 crore) level. The Stock futures versus Nifty futures open interest ratio is approximately 73:27. Cost of carry in stock futures has jumped from 30–40 basis points to 70–80 basis points per month, indicating that speculative activity in the market has increased. The Nifty has corrected 10–15 per cent, whenever, the above mentioned ratio has surpassed 70:30.

Implied volatility (IVs) of Nifty options has dipped to around 16–17 per cent, lowest ever in India and the lowest in the world currently. Obvious explanation lies in the recent reduced level of volatility, but it is also evident that it cannot sustain at this level. Currently, the IVs are at two standard deviation away from the 60 day mean level of volatility and is bound to revert to the mean. Volatility typically never goes up in a rising market; it has to coincide with fall in the market. This is what induces me to believe that correction in the market is imminent.

What are markets ignoring? Current account deficit has been rising and impact on Rupee has been largely neutralised by strong foreign flows. Even a small slowdown in the flows will pose a significant currency risk and risk to market. Flows can slow down or stop for a month or two, even if structural story remains intact.

No doubt, corporate results have been strong, but margins are definitely under pressure. Profitability growth has been lagging revenue growth and I see the trend continuing for some more time. Positive operating leverage worked last year, but as the environment has improved and cost of doing business is rising, negative operating leverage will come to the fore in the next few quarters. This leaves a significant scope for earnings downgrade. Also, implied growth rate is one of the highest in the whole decade at 11.4 per cent.

Five states are going into election in next one year, which can lead to some political realignment and upheaval.

I do believe the long–term India story remains intact, but markets are poised for an 8–10 per cent correction in the short term. It’s time to increase cash levels.

The author is EVP and Head-Institutional Equities, Edelweiss Securities