Budget 2018 impact: Indian stock market's reaction is fairly bearish

The market's reaction to the Budget is fairly bearish. This can partly be explained by the imposition of tax on long term capital gains (and dividend distribution tax on equity mutual funds) on equities. That has hurt Indian investors. The foreign portfolio investors (FPI) may have some protection if they are operating out of tax havens. But, FPIs have also turned wary due to the expansion of the fiscal deficit to 3.5 per cent of the GDP in 2017-18, and the inability to curb expenditure in 2018-19. The FPI reaction has also caused a spike in the US dollar with the rupee falling sharply in the past two sessions.

 
The Indian bond market has also responded bearishly with a spike in sovereign yields. The yield of the benchmark 10-year bond has risen to a 22-month high. This clearly signals a market that expects interest rates and yields to go up. In fact, the bond market has been looking bearish for several months. Financial sector stocks, including banks did pretty badly on Friday.
 
The technical reaction is clearly broadly bearish. Small and midcaps, which have a large retail presence, have done even worse than the Nifty and Nifty Next50. The crash on Friday will have triggered popular trend-following systems, which means more selling is likely.

 

Trend-following systems assume that a trend in either direction will last, until some pre-set stop-loss is broken by a trend reversal. When a stop is triggered, many trend following systems advocate taking a reverse position. The crash on Friday, may mean more sell signals in future sessions, as traders close out long positions and take short positions. Inexperienced retail traders could cause more grief ifthey panic and redeem mutual funds alongside directequity sales.
 
Two positions appear tempting at the current moment. One is the long dollar-rupee position, which assumes that the dollar will snap back quite a lot higher, from current levels. Second is the deep, relatively cheap long put at say Nifty 10,500 or even Nifty 10,000. This settlement has three weeks to run (till February 22) and the market could easily fall another 3-5 per cent in that period. There is also a case for taking a long March Nifty put at 10,000. The market has run straight up from 9,650-9,700 since last September. It could give back 500 - 1,000 points of that move equally quickly. The 200-day moving average of the Nifty is sitting at around the 10,000 mark and it is very likely to be tested if the selling continues.

 
In terms of possible hedges, the information technology (IT) sector could regain some importance. It is positively impacted by a falling rupee and most IT majors are low debt entities that are more or less immune to changes in the rupee interest rate. Pharmaceuticals have also underperformed the market for almost two years, but they may see some rebound based on the dollar-rupee equation. FMCG is one domestic sector that did not see massive selling on Friday. The worst hit sectors included financials, public sector banks and realty, which all saw very heavy selling. Energy also got hit hard, probably because higher crude oil prices are a cause for concern.