Some recent forecasts suggest further weakness in the US economy. There is uncertainty in the global metals market. The second half 2010-11 guidance from Infosys is muted, due to worry about a rising rupee. India's Index of Industrial Production (IIP) numbers have dropped.
Put this all together. Is it a recipe for a correction in the Indian equity prices? Arguably so. The market hit new 32-month highs this week and then dropped, two sessions in succession, with selling in huge volumes across the board.
The macro-economic outlook is rarely black and white. There are almost always both positive and negative variables at play. For example, several economic institutions including the IMF have upgraded India's 2010-11 GDP estimates despite the IIP slowdown.
That should translate into stronger earnings growth in most sectors. When the market wants to, it shrugs off bad news or weak forecasts.
When it wants to, it ignores the good news. To directly link macro-economic projections to stock price movements runs the risk of over-simplification, even though it's always tempting to seek explanations that slot easily together.
There is a purely technical perspective to price movements. The technicians would say a correction is likely. It's overdue after 19 weeks of gains that have pushed the Nifty up 30 per cent.
In such circumstances, traders generally look for any excuse to book profits. The sellers will seize upon post-facto justifications for actions they would take on any signs of potential weakening.
However, this rally was remarkable in that it had only one driver in strong foreign institutional investor (FII) inflows. Between June 1, and October 14, the FIIs poured Rs 58,000 crore worth of net purchases into Indian equity, while domestic institutional investors (DIIs) sold over Rs 38,000 crore (Rs 380 billion).
The overall volumes and the differentials between FII-DII commitment make it clear that only the collective FII opinion mattered during the past four-and-a-half months. If the FIIs now start selling for whatever reasons, it is extremely unlikely that the DIIs would be capable of counterbalancing. Nor are they likely to.
It would not be logical to expect DIIs, who have been net sellers since Nifty 5500 levels to start buying at 6000-plus.
On Friday October 15, the FIIs were net sellers for the first time since September 7 (DIIs also sold on October 15). One session of sales doesn't necessarily signal a change in FII attitude. But it might be enough to spook other market participants, given the pattern of the past several months.
If a pattern of simultaneous net sales from both sets of institutions develops, the market could fall very fast and for quite a distance. This is even more likely to be the case during the festive season when operator action also tends to be low-key and often, negative.
Again, from a purely technical perspective, a correction of 7-10 per cent would not be unusual, after a run up of 30 per cent. It could be a deeper correction. The depth of the correction would be just as much a function of FII attitude (and more broadly, overall institutional attitude) as the previous run up was.
Of course, this is extrapolating quite a lot more than may be warranted from just two down-sessions in a row.
Technicians would want confirmation that this is indeed the start of a genuine trend reversal over the next week or two. But a correction is due both on technical grounds and in terms of over-valuation, and the broad signals do seem to suggest that it is kicking off.
October could be quite a choppy month if this is indeed the start of a trend reversal. Rather than outright panic, a scenario of net losses interspersed by occasional pullbacks looks probable.
Typically volumes should ease as prices fall. A trader could try to ride such a downturn. Derivatives with their inherent leverage are alluring but dangerous. Although there are excellent prospects of quick profits, there are also risks of big losses.
The safest way to short is to buy Nifty puts only the premium is at risk. A reasonable alternative is to sell a Nifty future with a stop loss, and also sell far-from-money puts. If the market rebounds, the short puts can be bought back for profits while the future is stopped out.
If the market drops, the futures gain, while puts can be reversed at some loss.
What can a retail investor do in such circumstances? Very little except sit on his hands and wait for events to unfold. There is little worth buying at current valuations. A deep correction will establish entry points lower down.
