Move outside 5,125-5,375 could lead to breakout

The initial reaction to the 50-basis point policy rate cut in the latest credit policy on Tuesday was surprisingly muted. The cut was definitely larger than the market expected and, of course, the response was positive. However, the Reserve Bank of India (RBI) also implied this was likely to be the only cut in the near future and said it remained worried about inflationary prospects.

Given a long cycle of rate rises, this puts the liquidity situation back to approximately what it was in Q2, 2011-12 (July-Sept 2011). The incremental credit deposit ratios of banks are tighter now than they were at that time and the government’s borrowing programme has expanded.

But the cut should be enough to reverse the trend of falling profit margins that have been noted in the last three quarters. If banks and non-banking financial companies pass it on to consumers, there could be a certain amount of volume revival as well.

Consumer-driven businesses are likely to find it easier to bounce back than big infrastructure and capital goods because retail/consumer business is less capital intensive. The tight liquidity conditions will ease somewhat but perhaps not enough to make it easy to find big-ticket funding.

The conventional wisdom is that financials respond quickest to rate changes (up or down) and rate-sensitives like autos, real estate, infrastructure and construction, respond reasonably quickly. Less cash-intensive businesses will obviously be less affected.

In terms of valuations, assuming the rate cuts work through the system quickly, the Nifty’s fair value would be about P/E 15-16 in the next three months. That is slightly lower than current levels. It means an investor would feel comfortable buying a broad basket of equities for the long-term. He should be happy to do so on a 10 per cent correction.

Technically, the market continues to range trade. It’s above the 200-Day Moving Average with an indeterminate pattern, swinging between 5,125-5,375. It may continue to range trade inside that 250-point zone for an indefinite period. A move outside that range could result in a 250-point swing in the direction of a breakout.

There are two things a trader can do. One is to try and catch moves inside that 250-point range, on the assumption that range trading will continue. This means going long if the index is at the lower end of that range and short at the higher end. This will mean a sequence of short-term trades with tight stop losses. The other method is to wait for a breakout. That would require patience. But it would afford more certainty as and when it happens.

The author is an equity and technical analyst