Keynesian dip

There's a Keynesian dip happening in the Indian markets since May 2003. The markets have dipped four times at an average of 6 per cent for about a week before continuing the uptrend again.

However, the dip last Friday has been a bit hasty. Nifty has declined by 4 per cent in just two trading days.

Though we have about 2 per cent more to go before we match the historical 'dip' average, the questions we debated in the past time seem to have been answered.

On November 24, 2003, we debated why Nifty should create another high (Nifty @ 1625) before a probable top. We mentioned about the mixed signals - viz. positive open interest (OI) and increasing volumes along with declining implied volatilities (IVs).

If these signals continued the declining trend to the sub 20 per cent mark, it could lead to a topping market. Well, the IVs did not decline and rather rose back to 25 per cent level.

And the markets witnessed a rise in OI and highest aggregate derivatives volumes at Rs 130 billion and Rs 180 billion respectively. Hence Nifty not only breached the 1625 high but has also moved up by 17 per cent since then.

Coming back to the dip, the possibility of the Nifty falling more than 3 per cent this week seems like an event to me. A more-than-7-per-cent drop will be the highest drop in the broad market since May 2003.

Moreover, with FII OI at more than Rs 50 billion and aggregate OI also at all-time high levels, such a decline in the Nifty will surely bring some panic to players confident about the 'dip theory'.

OI has been in an uptrend since the start of this rally. This is a typical situation whenever the equity markets gain momentum to the upside.

There is a large pickup in participation and an increase in OI. However, a perilous market situation occurs when there is a persistent pattern in which the OI rises but the market is unable to close at a new high.

Something like what we are seeing today. The Nifty closed near year-end levels on Friday despite an increase of about 31 per cent in the number of OI outstanding contracts.

Trading volumes also increased by about 16 per cent during that period without any support from the rise in the level of Index.

Both F&O aggregate OI and volume have upward-sloping 20-day averages despite Nifty's inability to close at a new high.

Whenever such a situation occurs at the same time - viz. increasing OI and volumes without any further rise in price - there is a consensus that the market has become overloaded with bulls and the public's buying is being met with selling by hedgers, who are determined to establish their short positions.

As a trader if you sell short in this environment, then you should stay short until a substantial liquidation of OI has taken place.

The hedging aspect is not that clear from the options market, as stock specific put-call ratios (PCRs) are still near historical lows for most of the heavyweights. Market-wide PCR, however, inched up on Friday moving to 0.23.

There are not many examples or precedents in the Indian market of such a contrary opinion in prices and OI.

However, we have witnessed such a case in the US in April 2000 when investors were buying whole hog.

This turned out to be disastrous timing for 'longs' but a classic opportunity to go 'short' because of the high consensus and the rising OI in a market that could not make new highs.

The longs or bulls got caught, and the power behind the subsequent decline was provided by long liquidation.

Stock specific, however, the things are divergent from the Nifty. The OI trends are down in ACC, Bhel, BPCL, HPCL, ITC, L&T, Reliance, Satyam, Tata Motors and Tisco. Infosys, SBI, M&M and HLL continue to be positive on the OI trend.

Overall, we have all signs of a tough battle between the bulls and bears in the coming week with the Nifty still in the clutches of the bulls trying to prove that what we saw last week, though hasty, was another version of 'The Keynesian dip'.

(The author is derivatives strategist at Edelweiss Capital.)