Market may be headed for a deep correction

Bulls had built up large positions speculating on a bigger rate cut of 0.5% by the MPC

The Monetary Policy Committee (MPC) cut the policy rates by 0.25 per cent in its review last week. The repurchase rate was pushed down to 6 per cent while the reverse repo was at 5.75 per cent and the marginal standing facility was adjusted to 6.25 per cent. However, the MPC held status quo on the cash reserve ratio (CRR), which remained at 4 per cent. The stock market was disappointed. Bulls had built up large positions speculating on a bigger rate cut of 0.5 per cent and some “super-optimists” were hoping for CRR easing as well. Hence, there was a sell-off in the stock market as a result. This sort of correction is usually referred to as “tired bull unloading”. 

The rate cut was a no-brainer. Inflation is ranging at a historic low of 1.54 per cent year-on-year (y-o-y) for the consumer price index (CPI) in June 2017. This is well below the lower limit of the Reserve Bank of India (RBI)’s stated tolerance range of 4 per cent +/- 2 per cent. 

In addition, there’s been a generic slowdown, triggered by demonetisation and made worse by early stages of GST implementation. This is visible in both the Index of Industrial production (IIP), which was at 1.7 per cent y-o-y for May 2017 and the eight Core Sectors’ growth rate of 0.4 per cent for June. It’s gotten worse; the Purchasing Managers’ Index for July indicated contraction in services and manufacturing. 

The policy statement speaks of "loss of speed in manufacturing." At the same time, the RBI believes that a delayed spike is due in food prices (going by tomato rates, it's already here). It's worried that household surveys indicate that inflation expectations are hardening. 

Will a 0.25 per cent rate cut stimulate activity? Most industries have surplus capacity and there are few capex plans on the anvil.  New investment plans hit a 12-year low in Q1, 2017-18. The RBI also suspects that farm loan waivers could compel a further cutback on capex plans. The policy speaks of "retrenchment of capital formation". 

Credit growth has dropped to historic lows and every public sector bank is more worried about loan recovery than about growing its loan disbursal. There is already plenty of surplus liquidity within the system — the RBI holds about Rs 200,000 crore worth of bank funds. While capex demand may remain muted, the GST may create a demand for more working capital - tax has to be paid upfront every time an invoice is raised and it's unclear how quickly the Income Tax Department will credit the necessary offsets. This could mean an extended credit cycle for already stressed industries. 

Amazingly, the RBI retains the overall GDP growth projections at 7.3 per cent for 2017-18 despite the very gloomy caveats. The monetary policy also projects CPI running at 2.0-3.5 per cent in the first half of 2017-18 and 3.5-4.5 per cent in H2. 

Maybe the market will see the policy statement as a reality check given the disconnect: stocks are hitting all-time highs while the central bank statement offers reasons to suspect the economy is close to tanking. Midcaps are trading at average valuations of PE 35 or more. 

The Nifty / Sensex stocks are at averaged PE 25 plus. Those valuations would have hard to justify with an economy roaring in overdrive. 

Given the adverse response to Sebi's action against shell companies, market sentiment may have changed. This could be a deep correction. It is the sort of situation where keeping a hedge of a long Nifty 9500 put might make sense. That costs Rs 23.50 at the moment and it could pay 5x if the sentiment gets worse.