"Once a boom is well started, it cannot be arrested. It can only be collapsed." - John Kenneth Galbraith
Depositors in the doomed-Silicon Valley Bank have been protected, but equity investors and bond holders have been wiped out. And shortly after US regulators shut down the New York-based Signature Bank citing systemic risk. Signature was one of the main banks to the cryptocurrency industry, the biggest one next to Silvergate, which announced its impending liquidation last week.
Global markets look all set for a bumpy ride over the next few weeks as investors try to guess the next casualty.
Back home, those betting on a ‘time-correction’ all the way till the next leg of upswing could do well to remember the above quote by the noted economist Galbraith. As the Silicon Valley episode shows, there is never an orderly retreat from a bull market. The excesses of the bull market at some point have to be purged from the system, and a time-wise correction more likely than not ends in a panic bottoming of prices.
Single stock futures
Two closely tracked F&O indicators are the outstanding FII net long/short positions in index futures and the retail investor net long/short position in single stock futures. While FII Nifty positions swing between net short and net long depending on market conditions, retail positions in single stock futures have consistently been net long 70 percent or more.
Why?
A part of these positions is a hedge as part of a derivative trading strategy, but a sizeable portion is funding transactions by promoters of mid-cap companies. The promoters sell shares from their benaami holdings to a financier. The financiers in picture could be wealthy investors or aribitrage schemes of mutual funds.
After buying the shares, the financier then takes up a short position of an equivalent quantity in the futures markets. Since futures prices are at a premium to spot, this difference is the interest rate that the financier is making on the deal. Think of it this way: the financier buys a stock at Rs 100 and then sells the future of that stock at Rs 101, pocketing a one rupee profit.
As for the promoters, he uses funds from the sale of shares to take up a long position in the futures market, and acts as the counterparty to the financier’s short position. The advantage for the promoter that he only has to put up 25-30 percent of the funds received from the share sale as margins for the derivatives trades. The remaining money is used for various causes, sometimes to pump up the stock price.
The positions get rolled over at expiry as long as the spread between the future and spot prices are wide enough, meaning financiers earn a meaningful rate of interest. If the spread narrows, financiers start closing out their positions. And when that happens, shares started flooding the system as financiers reverse the cash market leg of the transaction by selling shares. That has a cascading effect on the stock price as it triggers margin calls and further selling.
In the days preceding the meltdown in Adani Enterprises shares, many arbitrage funds had unwound their positions as the spreads narrowed. This added to the supply of shares in the system, putting further pressure on the stock.
Watch the single stock futures space closely.
Time correction
The widely held view among market participants is that a time correction—where prices stay stagnant for a long time—is more likely to play out than a sharp price correction. That’s on the assumptions that
a) India’s economy is in a better shape relative to peers
b) Corporate balance sheets look good
c) SIP money into mutual funds will limit downsides
d) Earnings momentum will pick up in the coming quarters
e) Investors will stay patient
The last point is the tricky part. When two-year returns start to turn negative, investors start losing their patience. What is keeping SIP money flowing in so far that a fresh crop of investors feel valuations are attractive, and are replacing those who have thrown in the towel.
Over the past two decades, it is hard to think of an instance where a bull market was preceded by a phase of time correction. Think 1999, 2003, 2014, 2020.
