This market rally will have legs - and for many reasons

Sentiment has changed and along with sentiments markets have changed. The sharp rally in equities, oil and the euro in just under a month are due to a combination of short-covering, relief and fundamentals.

Equity indices across the globe have rallied 5-10 percent month to date, oil has gained 15 percent and the euro has rallied over 4 percent against the US dollar. In India, the Sensex and Nifty are up over 5 percent month to date while the rupee is down by over a percent. On Friday, the Sensex seemed to be taking the optimism further. The rupee is yet to catch up with the equity rally, but it will do so in the coming weeks.

[caption id=“attachment_118262” align=“alignleft” width=“380” caption=“The Sensex and Nifty are up over 5 percent month to date while the rupee is down by over a percent.AFP”]  [/caption]

The much-speculated European Union (EU) agreement on a bailout package for the eurozone came to a conclusion on 26 October 2011. The EU leaders agreed on leveraging the size of the bailout fund. The EFSF (European Financial Stability Facility) is to be leveraged four to five times to take up the size to 1 trillion, an amount large enough to prevent Greek debt default contagion spreading into other eurozone nations.

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Greek bondholders have agreed to write down 50 percent of Greek debt on their books in exchange for sops and more capital. The ECB (European Central Bank) will remain independent but will continue its bond purchases to calm distressed markets.

The EU agreement will provide a boost for markets that has been worried about the debt crisis in the eurozone. The EU agreement itself will not turn around eurozone fundamentals quickly, but it will stem the tide of selling short Europe.

Short-sellers on the euro, eurozone credit and eurozone equities have been having a good time, given the sharp fall in equities and currencies (by over 15 percent in equities and 10 percent in the euro) and the rise in credit spreads by around 100 basis points (1 percent) since the beginning of August. Short-sellers are now covering positions on the back of the EU deal and hence the rally in European equities by over 10 percent and the euro by over 4 percent month to date.

Credit spreads on eurozone credits are also trending down with default swap spreads down by 35 basis points in the month to date. Short-covering will continue until short positions come back to normal and this phenomenon will keep markets up.

The Indian markets have got relief from two fronts. One from the EU and the other from RBI. The RBI has guided markets for a pause in rate hikes for a while and has even suggested that policy can turn neutral from tight if inflation comes down below 7 percent. Equity, currency and bonds greeted the RBI’s policy positively with a rally. The market will look to build into the rally given that no fresh negatives are on the immediate horizon.

On the fundamentals front, prospects of stability in Europe and a shift in monetary stance by the RBI are positive. If speculation on eurozone debt comes off, markets can get back to business as usual and start looking at macro and corporate date for direction. The RBI’s guidance of no rate hikes in the coming policy reviews will let markets stop worrying about future policy surprises and instead focus on judging the potential of inflation coming off below 7 percent.

The negatives are out for now and there could be positives ahead. It is better to be long than short in the current scenario.

Arjun Parthasarathy is the Editor of www.investorsareidiots.com, a web site for investors.