Market falls trigger different behaviour among investors

The Nifty has dropped over 1,300 points from its peak, a retraction of 11 per cent. Smaller stocks are down even more. Importantly, all the major stock indices, the Nifty, Sensex, Nifty Next 50, Nifty 500, and the Midcaps, Smallcaps, etc, have broken down below their respective 200-day moving averages. This indicates a broad bear market which reflects bearish sentiments across most investor classes. Sector-specific indices are also down to bear market territory.

This is the kind of move that triggers different kinds of behaviour in different investor classes. The vast majority of retail investors are traders by nature. They are looking for investments that will yield quick returns while being “long only” by inclination. They lack the sophistication or the courage required to hold a long portfolio through a big bear market. They will either sell their holdings, or reduce future exposures, while holding onto current portfolios. This will affect both direct equity holdings and also equity fund behaviour.

We should see reflections of this in changing mutual fund allocations in October. Many equity focused SIPs which come up for renewal will not be renewed, or will be renewed with smaller quantum. It’s worth noting that the minimum period of a SIP is six months, and a significant number of SIPs were taken in April at the beginning of the fiscal. Lower SIPs and higher redemptions will create some selling pressures for equity mutual funds, which will be hard since the industry has already been adversely affected by poor returns in the debt segment.
 

Another class of “investor” is the pure momentum trader. This includes hedge funds as well as retail players. They have already switched to short from long in attitude. If the market falls further, they will put more money into the short side by buying puts, selling calls and going short in the stock futures segment. This creates a momentum effect where prices fall even further.

The third category is the committed long only buyer who never goes short. This includes some domestic institutional investors and some foreign portfolio investors, as well as some retail investors. This category will continue investing even if the market falls through the next several months or longer. The logic is, at some stage prices will hit bottom and if you keep buying, you will reduce your average acquisition prices since you will have bought at the bottom or near it. Eventually the market will bounce, and the long term returns will be okay. This is fine if you can consistently pursue the strategy, however long it takes for the turn around. That requires courage and deep pockets since bear markets can knock 50 per cent off peak prices and bear markets can last years.

The bear market could intensify, given a combination of poor macros, and political uncertainty that will last until at least middle of 2019. The global negatives - higher oil prices, a protectionist US, Brexit, tightening money supply, etc, will not go away. The momentum traders who go short will stand to make a good deal of money as prices go lower.

The committed long investors will make money 2 or 3 years down the road as they reduce their acquisition prices. They may suffer huge losses in the interim but this strategy depends on not booking losses. So they must hold and add, to their holdings.

The uncommitted long only players will lose huge sums. First, they will not add to their holdings as prices fall, so their acquisition prices remain high. Second, this class tends to sell close to the bottom as prices fall and patience runs out. Unfortunately most retail investors are in this class.