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The recovery will not accelerate this year

George Soros's principle of reflexivity appears to have operated quite strongly in the market. Overheated stock prices before the Budget have now given way to an exaggerated reaction with prices in most sectors having dropped past rational level to the point where they would be considered cheap.

In such circumstances, fundamental analysis is little help to the under-capitalised. If you have deep pockets, and the ability to stay invested in a broad range of equities for an indeterminate period, you will certainly make money in the long run. You can hardly lose at these prices.

Most of us aren't that lucky. The key question is whether one should simply stay cash-rich until such time as there is evidence of a turnaround. The market could fall further, it could stay range-bound for a long period, and it could enact a spectacular turnaround.

The last time one looked for technical targets on where this market could land, likely retracement levels appeared to be in the 3800-3900 Sensex zone. This zone was reached in trading during the last few sessions. Some bottom fishing is already apparent. However, the sheer speed of the fall leads one to suspect a degree of under-estimation in the downside.

Let me elucidate the basis on which one works out targets. It is usual to use Fibonacci series to calculate likely trend reversal points. The last major market bottom came in November 1998 at around 2740. From December 1998 to February 2000, the market saw a classic 16 month bull-run with an intra-day top coming at 6150 points in late February.

The subsequent pattern has been falling tops and bottoms. In three months, the market has hit a current low of 3831 point. This is a 68 per cent retracement of the 3400-point rally. That isn't a normal retracement zone. It exceeds the 61.8 per cent level and the 66.7 per cent level, which are both considered normal on different Fibonacci series. The next normal retracement point would be at the 75 per cent mark, which is around 3600 points, 3595 to be precise.

That would be an absolute retracement of 41.6 per cent from the top. In absolute terms, the retracement has been around 38 per cent. It was 41 percent in the bear market between 1994-1998 and 57 per cent in the 1992-93 bear market. We could thus be pretty close to a bear market bottom in terms of value.

What we haven't had yet is a rally after the bearishness started. A rally may be defined as a sequence of rising tops and bottoms that lasts at least a fortnight. This lack of a rally complicates time calculations.

One uses similar Fibonacci ratios of time periods to look for inflexion points where trend reversal could start. But the error level is far higher when one doesn't know the initial point of retracement, that is the first rally. Once one has the first rally, it is possible to construct likely Fibonacci series.

Broadly one expects a bear market to last rather less than the duration of the preceding bull market. As the 1994-98 period showed, there can be extended bear markets although there were several sharp rallies during that four-year period. Assuming that the long bear market was an outlier, we could expect a period of between 4-16 months as the normal tenure for this bear market. We have just crossed into the fourth month of falling prices.

Could there be a turnaround in early June? A Fibonacci calculation suggests it is a possibility. More possible turnaround points are clustered in August-September. There is a possibility of a gradual trend reversal with range trading and a slow recovery. Frankly, that is the toughest situation to diagnose and the one most likely to erode investors' net worth simply by the costs of carrying positions.

Let's look at the available cash factor, which will always influence market trends. The external position isn't good. The Nasdaq continues to fall. The latest US interest rate hike appears to have been absorbed but the Federal Reserve is clearly prepared to hike again and again until it tames inflation and deflates the US asset bubble. Every hike is liable to make US investors less happy with equity.

Foreign institutional investors (FIIs) have remained net positive on India since the new government was installed in November. But they will pull back if the cost of money rises. There are also increasingly attractive prospects in the recovering Tiger economies of East Asia. Morgan Stanley Capital International has recognised that situation with its re-balancing of the MSCI Emerging Markets Index that includes Malaysia and cuts India weightage. This is likely to induce a revaluation with FIIs also cutting India allocations. The net effect would be that FIIs cool off slightly while still going bargain-hunting.

The internal position isn't too good either. Real interest rates are dropping because inflation is rising quickly. But the government is committed to borrowing Rs 1.17 trillion this year - about Rs 45 billion every fortnight. This is likely to impact money supply and hence investments.

In order to keep money supply stable, the Reserve Bank of India (RBI) will have to make repeated sterilised interventions in the forex market. The process would be to buy dollars, and sell rupees to balance those taken out of circulation by the issued debt. Carried to a logical conclusion, the RBI would have to buy about $25 billion this fiscal.

The sheer magnitude makes it unlikely. The likeliest scenario is that the RBI will do enough dollar buying to push the rupee down, but it will not completely balance the domestic borrowing programme. So there will be some squeeze on money supply. Exporters will gain, so will domestic industry sectors that are in direct competition with imports. But the market will see a shortage of available cash and that could lead to a further drop in prices.

In macroeconomic terms, the recovery will not accelerate this year. Two bad monsoons in a row will impact consumer demand sharply. Growth will be respectable without being extraordinary. It remains to be seen whether clearance of 100 per cent foreign direct investment in power and telecom will necessarily translate into projects on the ground. Not in this fiscal, I suspect. There are too many other regulations, which need to be junked.

It all comes back to government intervention, which is the most unpredictable of factors. Can the government manage a drought and bad monsoon situation without letting prices spiral out of control and suffering a political backlash? Can it regain the courage it showed in its head-on confrontation with UPSEB workers? If so, there is hope of reform in the power sector. Can the government also follow through on a few more public sector divestments after Modern Foods?

The sale of PSU assets would raise cash, cut future financial outlays and free resources. Finally, can the government take on its own entrenched monopolies in telecom and insurance? These are all necessary but not sufficient conditions for an immediate rally. That would only come about if the government signals were good and somehow more cash became available as well.

Devangshu Datta

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