Monetary policy review: Trading strategies

In the last fortnight, RBI's credit squeeze led to the Bank Nifty being hammered from 11,700 levels to below 10,500

The Nifty is the premier index of the Indian stock market and has broad representation of many sectors. Since it’s not equally-weighted, heavyweight stocks and sectors have a disproportionate effect. The National Stock Exchange uses the standard free-float methodology for weighting. This pulls the weight of closely-held stocks, such as public sector units.

Banking and finance (B&F) have the highest combined weight. There are three public sector and five private banks in the Nifty, comprising 22 per cent. HDFC and IDFC take the weight to over 29 per cent.

The next highest representation is the combined energy sector, which includes stocks operating in power, refining, oil exploration, etc. Energy has a weight of 16 per cent – RIL (7.5 per cent) and ONGC (three per cent) are the biggies. The third highest is consumer goods, which includes fast-moving consumer goods (FMCG) companies ITC (7.5 per cent) and HUL (3.7 per cent) and adds up to 13-14 per cent. The fourth highest is information technology (IT), 11-12 per cent.

These four sectors contribute 75 per cent to the Nifty. Energy, FMCG and B&F have moved down. IT has been a hedge since it's held ground.

B&F is high-beta and internally-correlated. Every individual stock has betas above one and so does the entire sector. HDFC and IDFC are well correlated to banking. The stocks in B&F usually move in the same direction. The Bank Nifty is also a highly-liquid index.

Energy is not internally correlated. Power stocks don't move in the same direction as refiners and oil-exploration stocks. Refiners and exploration stocks can move in different directions. FMCG is not excessively correlated. Hindustan Unilever and ITC can move in different directions. IT has just three stocks in the Nifty and Infosys is sometimes out of step with TCS and HCL Tech.

In the last fortnight, the Reserve Bank of India (RBI)’s credit squeeze led to the Bank Nifty being hammered from 11,700 levels to below 10,500. That 11 per cent loss has reflected in the Nifty to much lesser extent, with the Nifty down 4.5 per cent.

If the RBI policy review doesn't have good news, the B&F will slide more. At the same time, the IT uptrend has been slowed by the rupee recovery. This could mean the Bank Nifty loses some more and the IT index also loses. So, the Nifty’s fall could accelerate. Unfortunately, the IT index is not liquid.

Apart from short futures on Bank Nifty and Nifty, there may be paired trades of IT and banking. These could mean shorting the IT futures and going long on B&F futures. The pair-trader may short HCL Tech and go long ICICI Bank. This gains if the price-gap between the two narrows. On the other hand, if the RBI does ease and the B&F sector hardens, one should ignore other considerations and go long on B&F.
The author is a technical and equity analyst