Why investors should be prepared for violent market swings

Will markets continue their upward trend despite the negatives that investors are seeing and feeling?

Liquidity, by nature, tends to overcome anything on its way and markets may well continue on their uptrend. However, the ill-effects of liquidity are many and that includes high oil prices and rising inflation. In such a liquidity driven market where fundamentals are yet to catch up, investors should be prepared for violent market swings. It is best to sell when others are buying and buy when others are selling in this market.

An unhappy rally

Why is the feeling of euphoria not there in the market rally of 2012? The Sensex and Nifty are higher by over 15 percent, while the rupee is up 7 percent since the start of this year. Government bond yields also are down by 30 basis points since the end of December 2012.

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The RBI cut the CRR (cash reserve ratio) by 50 basis points in its January 2012 policy review and is expected to cut the CRR and repo rates in its March 2012 review. Inflation is down to a more than a two-year low of 6.55 percent for January. FIIs (foreign institutional investors), who were net sellers of equities in calendar 2011, are back with a bang, buying $5 billion worth of equities in the first two months of 2012. Investors should be cheering with joy and looking forward to more good times.

[caption id=“attachment_224905” align=“alignleft” width=“380” caption=“Last year was all about the collapse of the eurozone, domestic inflation, scams and political inertia.”]  [/caption]

Yet the happiness factor in this smart market rally is absent. There are many reasons for this.

One is that investors would have taken their losses and stayed out of equities in the gloom and doom scenario that was painted in 2011. Last year was all about the collapse of the eurozone, domestic inflation, scams and political inertia. Investors are also nursing their wounds in losses incurred in the high-flying sectors of infrastructure, reality and energy, which are still down 8 percent, 42 percent and 80 percent, respectively, from the levels seen in February 2008.

The news coming out of the corporate sector is not encouraging either. The virtual collapse of Kingfisher Airlines is a rude awakening of mismanagement and poor government policies. The fact that many companies, including past market favorites such as GTL Infra and Suzlon, are slated to default on their FCCBs (foreign currency convertible bonds) obligations highlights the plight of heavily indebted companies in an unforgiving market.

In addition, large-cap companies such as Tata Steel and Ranbaxy have shown losses for the fourth quarter, and while one would want to look at future prospects rather than past performance, the economic conditions around the globe do not warrant great optimism for investors.

The sharp rise in oil prices is again a huge shock for the economy. Oil prices have risen 15 percent this year largely on the back of geo-political tensions over Iran and in sympathy with a broad risk assets rally. The economy, at this stage, cannot absorb an oil shock as the government is floundering on its finances, with the fiscal deficit set to be one percentage point higher from budgeted levels for 2011-12.

The RBI too will find its hands tied in its policy loosening measures as it has been forced to buy government bonds to fund the extra fiscal gap and to add liquidity into the system. The RBI is set to buy close to Rs 1,00,000 crores of bonds in 2011-12, the highest ever on record.

Investors will continue to feel unhappy, even if the market continues its upward momentum. The liquidity factor, with central banks from the ECB to the Bank of Japan pumping in money into the system that is driving the rally, is making investors nervous as liquidity increases volatility and sharp corrections are not ruled out. The images coming from the media in the form of violent protests against austerity measures in Greece and other European countries, corporate debt defaults and other negative economic news add to the feeling of unhappiness over this rally.

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