Short-selling 'fundamentals'

SMARTSHARE

Short-selling is frowned upon by regulators. For some reason, it's considered sinful to make money on downtrends. The Tehelka witch-hunt focussed on First Global's short-selling which was sought to be presented as a crime in itself despite being quite legal.

Short-selling is difficult to implement and requires discipline and timing. The risk: reward equation is less generous than with long positions. The upside on a buy is infinite whereas a sell yields a maximum of 100 per cent.

A long operator can borrow money if need be, to squirrel away stock and hold indefinitely. A short-seller can, at best, borrow the stock and delay buyback. It's easier to borrow money than to borrow stock. One of the nastiest experiences is getting squeezed when the buyer insists on delivery and the stock is unavailable.

You can buy on improving fundamentals but it's prohibitively expensive to borrow stocks long-term and short on declining fundamentals. You can short on news (as opposed to fundamentals) since prices respond quicker. Even then, it's risky. Regulators tend to enforce higher margins or ban shorts altogether in disaster situations.

It's not yet clear if India is a "fundamental" short. That is, should traders be net sellers for the next six months on the basis that the economic cycle is weakening?

There are signs the cycle is peaking. Interest rates are up; losses on the petro-refining front are big enough to drag-down the universe of corporate profits.

Against that, corporate earnings (excluding refining) and turnover growth looks strong. And, business activity, including infrastructure building, continues at a rate where GDP growth is unlikely to tail off drastically.

But corporate growth and profits may run into a wall if rates keep rising. The Indian economy is very dependent on consumer activity and that makes it inordinately sensitive to sentiment and thus, to rising rates. A 25-30 per cent drop in the stock market could mean consumers tightening their belts and slowing growth.

The retail response to upcoming IPOs like DLF, PFC and PGCIL will be a crucial pointer to retail sentiment. The other thing I would track is the housing loans market.

In an under-indexed economy, housing finance is a good surrogate for consumer sentiment despite mortgages accounting for only about 4 per cent of current GDP. If you're prepared to exit housing finance, the Indian economy is probably a fundamental short.

We might take HDFC and LIC Housing Finance as surrogates for the sector. Thus far, HDFC hasn't shown a slowdown in business. In fact, Q4 2005-06, saw faster growth in operational income at 29.8 per cent compared to Q4 2004-05 than the full-year (25.4 per cent growth in FY 2005-06 over FY 2004-05).

But interest charges have grown even faster than loan income "" Q4 interest costs rose 34.4 per cent compared to Q4 2004-05 whereas FY 2005-06 interest charges grew 27 per cent over FY 2004-05. Spreads have declined very marginally.

LIC Housing has similar patterns for the first nine months (April-Dec 2005) with a 19 per cent jump in turnover versus a 24.4 per cent rise in interest costs.

It isn't enough to make a housing finance a fundamental short but rate hikes always have a lagged effect. If the trend of lower spreads and higher interest costs continues, it would be a sign that the mortgage market is slowing down. And that would mean the entire economy has peaked.