Betting on bonds

Before there is any economic recovery, there will be a bond market rally

Most practical traders trust price signals only if they are confirmed by a clear correlation with volume signals. The thumb-rule is that volume should go up when prices go up and volume should fall when prices drop. Exceptions are considered negative divergences.

This can be understood simply in terms of supply-demand. If the demand for shares is up, and supply doesn't come in at prevailing prices, both prices and volumes rise. Similarly if demand falls, prices will drop and volumes ease off. So, if prices rise but volumes don't, the uptrend is probably not backed by genuine demand. Conversely if prices fall and volumes rise, you have a dangerously strong downtrend and possibly, a panic sell-off situation.

The last 10 weeks or so have seen volumes multiplying as prices rose so there is no absence of current demand. In those circumstances, a trader will continue to hold long positions. The prudent trader will set trailing stop losses that are moved up while prices rise. That locks in some profits if the trend reverses.

However, what should the equity investor do? The answer to that question depends on the individual's assessment of the nature of economic recovery. Let's assume for argument's sake that the market rally is a leading indicator of an economic turnaround. However, even if this is so, the recovery may be shaped more like the letter “w” than the “v”.

If it's a “v-shaped” rally, investors should be rushing to get into equity for fear of being left behind. Indeed, this is happening with erstwhile fence-sitters committing money in the past couple of weeks. If it's a “w-shaped” rally, the smart money should be waiting for a correction.

In terms of fundamentals, the global economic situation presents only the first glimmers of hope. Nobody is forecasting a quick recovery anywhere. India is pretty much tied to global conditions though it should remain among the highest-growth economies. There is little anecdotal evidence in favour of fast recovery in India. Almost every Indian business has seen salary freezes and layoffs in the new fiscal and hiring patterns don't indicate enthusiasm.

Interest rate trends and differentials are too large for comfort. Rallies tend to come when real rates are negative and the differential between AAA commercial debt and treasury yields is minimal. Inflation (as measured by WPI) is below 1 per cent. Policy rates like the Repo (4.75 per cent) and Reverse Repo (3.25 per cent) are high in that context. T-Bills are trading between 4.5 per cent (1 year) and 7.65 per cent (long-term). PLRs are in the range of 12-13 per cent and banks are offering fixed deposit rates of between 7-9 per cent.

Inflation is very likely to stay low until September -October 2009 because of base effects, if nothing else. So policy rates and government yields must come down further and so must the entire structure of commercial debt. Unfortunately, the government's huge borrowing programme and massive deficits makes this a slow, difficult process.

The market is also trading at average PEs that cannot be justified by any of several valuation methods. Given 2009-10 earnings growth expectations, the current Nifty PE of 21 offers a forward PE-G ratio of over 1. Given interest rates, a yield comparison to earnings suggests that PEs of better than 15-16 are rich. That could mean a correction of 20 per cent from current levels if fundamental expectations are borne out.

Nevertheless, the uptrend has been so strong, it is psychologically difficult to sit upon one's hands. If you are invested in equity, you should stay long and cross your fingers. The key difference between an investment perspective and a trading one is that an investor should come in on corrections whereas a trader should exit and reverse positions.

There is an alternate investment that makes sense. This is medium-term debt funds – that is, debt funds that specialise in medium-term instruments. Before there can be a sustainable economic recovery, there must be a bond market rally.

There is very limited downside to holding debt instruments at the moment because both Treasury yields and commercial rates must drop. This is in contrast to equity where there could be a severe downside if it's a w rather than a v.