"We simply attempt to be fearful when others are greedy and to be greedy only when others are fearful"
                                                                                 - Warren Buffett

CNBC-TV18's research analyst, Haresh Soneji - Bears like this – volatility, with a downward bias. Over a quarter now, the Indian markets, on the back of global uncertainty, have been providing fuel to the bears. Are we at a turning point is the question that every investor wants answered. Some experts feel the bottom has been achieved and things would start looking up. They have a point, but perhaps a biased point. Although we may be near a bottom, there is a very valid reason to take the experts words with a pinch of salt. One key reason is that India has been a long only market. So, most experts themselves are long only players. Therefore, their opinions may be biased to that extent.

Agreed one could be short on the Indian market with the help of derivatives, but there are restrictions. But, that won’t be for too long. India allows short selling from April 21, after seven long years, in a controlled manner. Short selling would be allowed only on 227 stocks in the F&O segment. It’s a good beginning. For those who want a completely free market, remember short selling the world over is a regulated segment. Thus, the Indian equity market now offers a complete package for institutions who would like to take a 360 degree view on India.

Having said that, let’s understand the impact of short selling on the Indian equity market. Is it positive or negative? A paper prepared by students of Cornell University concludes that short selling improves market quality. True. Sebi has been fighting hard to do away with manipulators and has succeeded a lot. Yet a few of them just keep propping up now and then. But, overall things are much better now than what they used to be a decade back. All that gyaan is good, but what is the point that we are driving home? The point is that there is a likely chance that market may go down further once short selling is permitted into the Indian equity market.

Let’s first understand the implications of short selling. Our text books tell us how short selling precipitates the fall in a falling market and restrains the rise in a rising market. So, where is the Indian equity market now? Since the closing high made on Jan 8, ’08, the Indian equity market has continuously made lower tops and lower bottoms. Every other rally is faced with a renewed sell-off. So, we are in a volatile market with negative bias. That’s a good sign for shorters.

Also historically, evidence suggests that equity market where short selling is allowed command lower risk/valuation premiums than a long only market. India has been a long only market since 2001. So, premiums were significantly higher. Even after the current correction, premiums in India are higher by at least 200 bps (basis points, 100 bps = 1%) than other emerging markets, after factoring in the India growth story. Shorters will grab this opportunity. A quick reference check shows that when short selling was earlier allowed in India, the growth story remained, but premiums were 50-100 bps higher than most other emerging markets. This in itself is significant room for play. And since shorters are near sighted, recommendations on the back of 2010/11 estimates would mean ideal hunting grounds to go short.

The global environment remains almost the same. The global economy was slowing down then on the back of IT bubble burst and the global economy will be slowing down on the back of sub prime concerns. With high chances of no earnings surprise this result season, shorters may have a little more at hand to play with.

Disclosure: The author is not permitted to trade and/or invest into the equity market directly or indirectly, apart from investing (long only) in mutual fund products.