Will December be the month for bears?

Purely in terms of supply-demand, if there's more money chasing the same number of stocks, prices will rise. Vice-versa, if there is less money, prices will fall. More money has been chasing the same stocks for quite a while. 

The number of investible stocks has increased but investment inflows have increased much faster. About five years ago, 40 stocks had a "mega" market capitalisation (m-cap) of Rs 25,000 crore plus and many of these were closely-held. Now, that list of mega-caps is around 80. Neglecting the inflation factor, the number of mega-caps has doubled. 

However, the AUM (assets under management) of large-cap equity funds has risen from Rs 60,000 crore in 2012 to around Rs 1,80,000 crore now. So, the amount of money chasing mega-caps has more than tripled — foreign portfolio investors (FPIs), multi-cap funds, etc, also buy mega-caps. As the National Pension Scheme gets going, it will add more volume. 

Even if we set a lower filter of say, Rs 10,000 crore as the definition of large-cap, there are only 150-160 such stocks and of course, there is even more institutional interest in that universe of Rs 10,000 crore plus.

Similar things have happened in the mid-cap space. The AUM of mid-cap funds has risen from Rs 30,000 crore in 2012 to over Rs 100,000 crore now. These funds can target 250-300 stocks with m-cap of between Rs 2,000 crore and Rs 10,000 crore. The small-cap AUM has risen even more dramatically in percentage terms, from Rs 2,500 crore in 2012 to Rs 25,000 crore today. 

The number of quality small-caps may have actually fallen since good companies have hit mid-cap status in the past 18 months. There have been 110 initial public offerings (IPOs) this financial year, raising around Rs 50,000 crore. But, that increases the liquid investible universe to around 600 stocks at best.

This presents a peculiar problem for fund managers. Funds cannot keep the bulk of their assets in cash, even if every fund manager of note admits privately (and some of them publicly) that valuations are stretched. Continuing inflows have forced them to buy into expensive PEs and also to overlook dubious fundamentals and dodgy management practices.

Normally, stock valuations are linked to interest rates because prudent investors tend to compare earnings yield (this can be calculated as the inverse of the PE ratio) with debt yields. However, PEs of 30+ and 50+ make a mockery of this. Even though interest rates and treasury yields have fallen, the safe return from debt is far higher than earnings yields. 

Where and how does this cycle end? Such a cycle creates bubbly conditions and eventually the buying could taper off. In that case, the bubble will deflate slowly. Or, there will be some major reversal of sentiment with investors selling out. In that case, the bubble will burst with a rapid crash because large redemptions would force funds to sell their holdings.   

Contrarians would guess the inflexion point is coming closer. The contrarian axiom states that, when everyone is bullish, everyone has also completed their buying and there is insufficient demand to push prices up any more. Well, everyone seems to be bullish right now. 

December is often a trigger month for outflows because FPIs tend to book profits at the end of their financial year. We’ve seen three per cent market swings in both directions in the past fortnight. A bigger downtrend could be sparked off if there's heavy FPI selling in the next two weeks. There could be all sorts of triggers ranging from unexpected policy decisions from any of the world's large central banks, to an upset win for the Congress in the Gujarat elections.