May 2006: Butcher's Paradise

May 2006 was an awful month, with the Sensex falling 22% in 12 days, from 12658 to 9826, and the Nifty, the NSE index, slipping 23%, from 3772 to 2894. They subsequently recovered, but the fall marked an important change in the unbridled run of the Indian stock markets.

Characteristically of secular bull runs, the corrective fall was rapid and, for the agape bulls, without respite. Millions watched as their capital eroded, and disappeared especially those leveraged long in the stock futures and options segments. For the first time, in the last 2 years, was an intra-day circuit brought in to play, since the indices fell 10%–the maximum limit they are allowed to–and trading was suspended for 1 hour. The last time this happened was May 17, 2004, when the Congress-led UPA government came in to power.

Just a few days ago, everything about India was glowing, and within a week it appeared as if nothing was right. Every bit of positive news was ignored. Theories abound that the fall was anticipated because the index had run ahead of fundamentals or were linked to FIIs moving out of emerging markets.

When it was all over and done with, some important ideas came to fore:

1. No matter how good the fundamentals, markets will always fall
2. Indian markets are purely liquidity driven
3. Indian markets are now inextricably linked to the owners of this liquidity–FIIs–and since most of them originate in the US, the developments in the US economy will have a strong bearing on their behavior in India.
4. How the government of India taxes these FIIs would drive the Indian markets
5. FIIs are now not just investors but also traders (hedge funds)

Quite emphatically, the Indian markets are directly linked to the larger fate of the US markets.
Fundamentals are good up to a point, but beyond this, it is all about hot money chasing hot stocks, and hot money originates in the US.

FIIs have about $35 billion invested in India, and point to note is the current fall was a result of a mere $1.8 billion moving out. Now imagine if $5 billion did!

With this in mind, it has thus become important for Indian investors to watch inflation and short-term interest rates in the US. A buzzing US economy is good, but too much of the buzz would drive up inflation due to rising real estate, commodity and energy prices. Real estate is already slowing down, but oil and energy continues to be high.

In so far, the Fed has increased interest rates 16 times in a row, taking it to 5% in May, 2006, however recent numbers indicate that the US economy could be halting. The possibility of rates being hiked once again in June to 5.25%, has raised its ugly head sending investors scampering.

The reason such small indicators are lapped up eagerly is because the Fed has said that it is unsure of what to do in the current scenario, and its policy makers are watching the economic numbers just like everyone else. So, cues in the Consumer Price Index (CPI), the Department of Labor’s Job Report and the Weekly Unemployment Insurance Claims are watched closely, and interpreted to show where the US economy stands.

May’s 5% freefall in the Dow and Nasdaq was a result of the CPI report showing an increase of 0.6% in April 2006. What halted the further slide was the DoL’s Jobs report which said 75,000 new jobs were created–a figure that was lower than expectations–indicating that the US economy was slowing down. However it has now brought in a new demon: Fears that an economic downturn is in the offing!

With this in mind, June 2006 would be an extremely important month for investors in India.