Devangshu Dutta: Almost irrational

WORM'S EYE VIEW

After the WTC attack, the Sensex fell 18 per cent in about a week's time. Over 3,000 people died "" several hundred of them were of Indian origin. The global economy went into a tailspin from which it hasn't fully recovered yet.

The market has fallen 24 per cent in a week since it became apparent that the National Democratic Alliance (NDA) was losing. In contrast to 9/11, there have been no fatalities since the BJP committed political suicide with a cocktail of silly alliances and absurd campaigning. The economy is doing as well as it was before elections. So, does the market's reaction to the election results betray lack of proportion?

It does. And, it doesn't. Market players belong to several different groups. Each of these groups acted rationally attempting to either make profits or limit losses. It was only the gross effect that was irrationally extreme.

The foreign institutional investors' (FIIs') take was simple: a weakening rupee, a probable hike in the US rates and some uncertainty about continuance of policy. Hence, take profits. The hedge funds saw both danger and opportunity in the uncertainty. Their reaction was Texas Hedges: sell equity and buy derivative bear-spreads to profit from further falls. Then, buy back equity at lower levels.

The more well-heeled Indian operators did the same thing as the hedge funds. The less well-heeled operators were pushed into selling by over-leverage. Cascading margin calls forced them out of the market. Day-traders and other short-term players were also forced to sell due to the same toxic combination of high leverage and margin calls. None of these groups had the money to buyback in meaningful quantities at Monday's lows.

Small investors sold in panic at the thought of their hard-earned money going down the tube. Even in panic, their actions weren't utterly illogical. If it takes a long time for prices to recover, it may make sense to cut losses and look for other avenues.

Nobody acted really irrationally. Yet, the net effect is a crash of near-unprecedented dimensions. The feedback from each bearish action caused another wave of selling. It's similar to what happened on "Black Monday" "" October 19, 1987 "" on Wall Street when the market dropped 20 per cent in a single session.

On both Black Mondays, there was no single trigger. Then, as now, the financial institutions (FIs) came in finally to support the market. It may be argued that the domestic FIs will eventually make fine returns (as the American FIs did in 1987) by acquiring equity at rock-bottom prices.

The FIs won't be the only ones to make money from the crash. The FIIs locked in profits; the hedgers gained on derivative positions. Some Indian operators now possess the same equity portfolios they did a week ago, plus cash from a combination of sales followed by buybacks and short derivative positions.

Equity trading is a zero-sum game "" somebody loses one rupee for every rupee that somebody else gains and trillions of rupees vaporised last week. One band of losers were the millions of small investors who got sucked into equity without possessing the acumen to sell high-buyback low or the wherewithal to average down like the FIs.

And, of course, over-leveraged traders drowned while fishing in troubled waters. That's an occupational hazard for professional traders, so it's tough to understand what they're protesting about. By buying during an election, they were betting on the outcome of a process mathematically akin to a horse-race. If the wrong horse wins, too bad!

I doubt whether the conspiracy theorists screaming about manipulation will find hard evidence. The Left Front spokespersons are not the sort to dabble in equity. The BJP-supporters who sold in large quantities were behaving rationally.

The market will soon move upwards if growth remains good under the new raj. If growth eases, we'll just have to remember Lance Klusener's unforgettable comment on South Africa's exit from the 1999 World Cup, "Big deal! Nobody died!"