The traditional drivers of the stock market, the FIIs, aren’t investing in a big way — so what’s driving the Sensex? The derivatives market may hold the answer.
Fundamental questions are simple to ask but difficult to answer. They cannot be answered with the same degree of certainty as one would answer the question ‘which direction does the sun rise every day’. One such fundamentally simple question for the stock market is ‘what makes stock prices and stock indices rise or fall’. The second-related, but more vexatious question is title of this piece itself. As an answer to the first, you will of course say that stock prices are based on rational expectations of the future, the stock market works on the auction-principle, and that prices are set by the forces of demand and supply. You will also add that, in an ideal efficient market, every buyer and seller has equal information and equal access to information, and that one person cannot influence the price of a stock by his or her action. This last one is a real killer because it assumes that we live in an ideal world. But why did these questions arise now you may ask. There are several good reasons — one of which is a bit eerie and hence I tread softly. It’s election time again, and one has not forgotten how our stock market markets reacted after the 2004 election on May 14 and 17.
While all this was happening, the global stock market Humpty Dumpty ignored Alice’s caution that ‘Don’t you think you’d be safer down on the ground?’ because ‘that wall is so very narrow!’ and James Tobin’s words in a 1984 lecture at the dawn of the economic boom that ‘…we are throwing more and more of our resources, including the cream of our youth, into financial activities remote from the production of goods and services, into activities that generate high private rewards disproportionate to their social productivity’. Consequently, it had a great fall. And what a fall it was. All the king’s horses and all the king’s men have not yet been able to put Humpty Dumpty back again. This is because some silly people did some silly things in the US to earn some silly money by selling some not-so-silly instruments which were only remotely connected to an asset class called housing. This has caused some tectonic shifts and fissures in the global financial system.
The Indian stock market at first looked the other way even on September 15; the theory of ‘decoupled’ economy was brought in; it’s happening there and not here, we live in an insular world, our economy is doing too well and all that. But in reality, FII money stopped flowing in. The froth in the beer mug had disappeared and the stock prices fell to levels which seemed to be good bargains. Investors were cajoled, exhorted, saying it’s time to buy as blood is running in the streets. But the lesson of the stock market is that the ordinary investors buy only after they are assured that the price rise will continue. So the investors did not buy, the foreign investors kept selling and so did the mutual funds and the Sensex fell as in a free-fall. With the drop in stock prices, there was also a distinct fall in property prices. Strange coincidence! The market gurus and the property-owners continued to make valiant efforts to convince us that the rains will come and everything will soon be green once again. But where are the rains; we are now in a drought, with no sign of any dark cloud on the horizon. In the meanwhile, the RBI gave the true weather forecast which maintained that the rains were still far away.
In this mood of despondency, suddenly signs of euphoria have emerged since March. The Sensex has climbed 3984 points or 46 per cent, from 8160 on March 9 to 12116 on May 7 in 36 trading days . The reasons though are not quite clear; some pundits have been attributing the rise to some remarks made at the Sunday service at the Trinity Church located at one end of Wall Street, that there would shortly be the birth of a new dawn. But beyond that nothing much seems to be happening, except that in India it is a period of glorious political uncertainty; the FIIs who were once the movers and shakers of our stock market made net equity sales (net of purchases) of $53 million in March, $104 million in April and a net purchase of only $68 million in May; the Indian mutual funds have been net sellers. But the question remains as to how the stock market index is rising. Are we in a cashless market? The answer may lie in the build-up and the churn in the FII positions and total positions in the derivatives market. If that is so, then it will be the curious case of the tail wagging the dog, the dog being the cash market and derivatives the tail. There is nothing wrong in it, but then one must know if that is the case.
If it offers any consolation to anyone, Chart 1 gives the decadal behaviour of the Dow, the Nikkei and the Nasdaq during crisis periods. There is an uncanny similarity with the S&P 500 so far under the current conditions. If this is anything to go by, we seem to be in for a long haul. In the meanwhile let’s wait for the weekend and keep our fingers crossed.
More From This Section
*The author was a former Executive Director Sebi and is currently associated with the World Bank and the Global Corporate Governance of the IFC