Decoding the stock market rally to new highs despite Covid pandemic

Momentum indicators suggest the market will keep running up until there is adverse news-flow; corrections as and when they come will be deep

The stock market hit a new high last week and continued to run up. There are many interesting aspects to this rally, which started about 13 months ago. One is disconnect between a rising stock market and fundamentals hit by the second wave when the economy had not fully recovered from the first wave.

On the technical side, look at breadth and volume. Is the rise of the major indices (Nifty/ Nifty Next, Sensex) backed by similar rises in smaller stocks? If there’s breadth and volume, across all segments, there’s more confidence about sustainability.

Also see the participants in the rally; is the buying from Domestic Institutions, FPIs, or retail investors? Rallies backed by institutional buying tend to last longer. If it’s retail buying and big money selling, the rally may not be that sustainable.

The Nifty is running at a valuation of PE 29-30 which is historically high. But PE has come down even as the index has risen. The last two quarters have seen corporate profits growing fast due to a combination of cost cutting and lower interest costs. But revenues have not grown much and revenues could come down sequentially in Q1 2021-22 versus Q4 2020-21, though the low base of Q1 2020-21 ensures YoY growth.

On the technical side, momentum indicators suggest the market will keep running up until there is adverse newsflow affecting sentiment, or change in market conditions. Breadth is good. The Midcaps and the Smallcaps indices have made new highs more or less in coordination with the Largecaps. There are more advancing stocks than declining stocks. The one negative signal here is that retail is more bullish than institutions. In May, FPIs have sold net Rs 6,015 crore and DIIs have bought only Rs 2,067 crore. Retail must have been responsible for the bulk of buying that pushed the market up.

In technical terms, you cannot set targets when stocks or indices are at a new high. Momentum players will just stay long and perhaps, set stop losses to ensure they keep some profit if there’s a correction. If retail eases off buying or institutions sell more heavily, the market will correct. 

On the fundamental side, investors will discount known factors such as drop in consumption demand in April-May caused by the second wave. It’s assumed this may continue for months, until the bulk of population is vaccinated, lockdowns ease and employment generation restarts.

Investors will also discount for rising inflation –fuel is up, metals are up, food is up. There could also be cost-push caused by higher global growth compared to India –imports (apart from fuels which are already high) will become more expensive even if the rupee stays stable.

But the RBI commitment to keeping liquidity flowing means real interest rates are low and yields from GoI (Government of India) instruments may edge into negative zone. This should induce more consumption and encourage more risky investment strategy.

It will take unknown factors to tilt sentiment. This could be some black swan event that is negative, such as a terrorist attack or the discovery of some major scam. But there may also be some positive news. The monsoon could be normal, leading to a drop in food inflation and better rural demand for example. Corrections as and when they come will be deep.