Should you join the rally?

Our columnist answers four questions related to the current stock market rally that are on everyones mind

Even as we gape at the sudden surge in the equity markets and wring our hands in despair about an opportunity we may have lost,it makes sense to reflect a bit on the past. First,if we did not know the top of the market in January 2008,we are equally unlikely to know the bottom. Second,if all the experts in the world could not tell us that a deep crisis was looming over the global markets,they are unlikely to know how and when the crisis could have blown over. The back-to-basics approach of looking out for good stocks and buying them at corrections,not after rallies,will always help us enhance our long-term wealth.

What does this surge mean?

Every bear market is interspersed with rallies. Investors tire of sitting out after a crash and begin to believe that the worst is over and in a collaborative auto-reinforcing action,begin to buy. A bear market bottoms out not because investors desire such an event,but because the real economy has completed its cleansing act. The optimists will point out that the fiscal stimuli across the world has prevented a collapse of the financial system and that the beneficial lag effect of rate cuts needs to show up. There is merit in this argument. But the next level of change has to come at the level of businesses.

Whats happening to businesses?

We need to see companies and banks cleaning up their balance sheets,reworking their strategies and looking better than they did when the crisis began. When the going was good,every business extended itself. Expansion plans that seemed realistic then now look stretched. When the crisis broke out,the first set of businesses to fail were the ones that ran out of cash it was not the collapse of the market or demand that led to their fall,but the simple non-availability of cash. Now that cash and liquidity seem to have returned somewhat to normal,it is easy to believe that businesses will turn around. The truth may be harsher. Longer-term solvency is a different issue compared to shorter-term liquidity. To the extent that businesses chased short-term growth spurts with scant regard for long-term sustainability,it will take a longer time for them to rework their strategies. The rally in the markets masks the difficulties that several businesses are facing in getting back on track,and that is the weakness of this rally.

What about technical factors?

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Is money not coming into the markets? Are we not seeing the return of the FII and the small investor? The truth is that money coming into the market at this time is purely driven by tactics to cut losses. After the markets fell initially,many investors would have expected a 15-20 per cent correction at the most. The adventurous would have bought some more to average out. The collapse to 14,000 levels was a nasty surprise. Investors would have mostly sat out,unwilling to book a loss. The subsequent crash to 8,000 levels would have left them numb with fear and despair. They would have seen their portfolios down by 60 per cent and decided not to invest any fresh cash inflows into the markets. What would such investors do when they see any sign of recovery? Some would deploy the surplus cash that they hold into the market to make good some of their earlier losses. The others may decide to sell,having missed the 14,000 level last time around. Therefore,what do we have in the market now? A set of tactical players who have booked profits to make good an old loss,and another set of conservative players who would like to book out. Technically therefore this rally will have more sellers than buyers at some point and will correct,even if it runs longer than most expect.

Should you jump in now?

What if the markets simply run up and away? A market runs away without correction only if buying interest is so dominant that any small correction brings in more buyers. Such quick corrections happen at the top. A rally from a bear market bottom corrects sooner rather than later,and corrects rather sharply,as players doubt the revival at every stage. When such corrections do not get worse than earlier lows,the signs of revival are visible. The confirmation of the ensuing bull market is therefore in the correction and not in the rally. Can one expect the correction after the elections? Unlikely. Because everyone is expecting it and is readying to buy when it happens,there may be buyers and not sellers in the market. If only we knew the specific events and turning points that represent the right time to buy or sell,we would all be fine. It is just that rally or correction,the market does not provide those specific signposts. u

The writer is MD,Centre for Investment Education and Learning

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