The need for caution

Beating The Street

The market has been running hot in the past few weeks in anticipation of the second quarter (Q2) results. These were expected to be excellent and so far, they've been pretty close to predictions.

Hence more money has come into the market and the indices have reached for new highs.

The advocates of caution in such circumstances are written off as fuddy-duddies.

However, there are sound reasons for not being swept away by the bullish fervour. It could well be that the market is due for a period of extended consolidation or correction rather than an uninterrupted bull run.

First of all, the early declarers of results are invariably those companies which have better-than-average governance and better-than-average performances.

It's dangerous to generalise projections from the first 100-150 company's workings. A more complete list of 2,000 corporates delivers less in terms of percentage gains than the top 150.

Second, even in this elite group of 150, results have been boosted by low Q2 2002-03 bases and non-replicable circumstances like sharp interest cuts.

Most companies have benefited from lower interest and done substantially better business than in the corresponding period of last year during recession.

Q3 results will benefit less from this statistical quirk and Q4 even less because the economy was pulling out of recession by then. Rate cuts were also less dramatic in the second half of 2002-03.

There is also such a thing as a surfeit of good news. When everybody is expecting good results, it is difficult if not mathematically impossible for every company to deliver results that are better than expectations.

Economists call this the "Lake Wobegan" situation, in honour of a fictional community where every child was "above-average".

In such circumstances even an objectively decent performance is considered disappointing.

Consider for example, what would have happened if Infosys had an objectively good 20 per cent growth instead of an outstanding 33 per cent. The stock would probably have gone into freefall.

Due to the fact that the first set of Q2 workings have been, by and large, above expectations, the expectations have risen.

There is also the "Diwali Effect". Except in the year of the post-Kargil 1999 elections and in 1997, when the late-year second Chidambaram Budget with its tax""amnesty provided impetus, post-Diwali trading has tended to be bearish or lacklustre, at best.

Traditional Indian investor communities tend to spend cash during this period rather than invest.

The FIIs clean up their NAVs and book profits because fund manager compensations depend on their positions at the end of December "" their reporting year coincides with the calendar. Most FIIs are loath to take long-term bets during the October-December period.

Another reason for caution is that market coverage is now extending down to smaller companies with less powerful balance-sheets and less sharetrading volumes.

These stocks can certainly offer large payoffs to the fast mover but they don't receive much institutional backing and thus, there's less stability in terms of shareprices.

A combination of the above factors could mean that shareprice gains over the next two months will be less exciting than the current consensus expectations.