No margin for error

 In the past two weeks, Indian markets have witnessed heightened intraday volatility. Out of the last nine trading sessions, on six occasions markets witnessed a sharp sell-off from the day’s high levels. Even though, on a weekly basis, Nifty managed to close with marginal gains, the jitteriness amongst traders is conspicuous.

The case of Last Friday is particularly noteworthy. The benchmark Nifty corrected almost 2% from the day’s high within a few minutes, ostensibly due to a media report suggesting implementation of the Direct Tax Code in the July 2024 final budget for FY25. The volatility index (India VIX) spiked over 33% to a multi-month high. The finance minister outrightly denied the report calling it “Pure speculation”.

 

In my view, three clear inferences could be drawn from this instance.

First, the market is bravely holding up, in line with the global trend. However, the risk appetite of investors and traders may be diminishing. The margin for error, should something go wrong, is very low. For example, if the financial performance of companies misses the elevated expectation levels; the outcome of general elections is contrary to popular expectation; and/or the monsoon is delayed or misses the “better than normal” forecast of the Indian Meteorological Department (IMD), the market may witness sharp corrections in the short term.

Second, the market participants have been very vocal in demanding material direct tax reforms for many years. The reactions to the market rumors of tax reform that may see higher tax rates indicate that the market’s idea of tax reform is nothing but lower tax rates and more exemptions (especially LTCG and dividend tax). There may be no appetite for a progressive tax structure that helps in an orderly wealth redistribution over a longer period without material impact on the revenue needed for the development effort.

Third, during the intraday sell-off, very large part of the market becomes extremely illiquid. The impact cost for selling in such a situation becomes very high. This is true, especially for the option traders. There have been many instances in the past two weeks where the hedges (stop loss) did not work; options became illiquid and even the hedged trades could not be squared; and small and midcap stocks hit lower circuits and could not be sold. If a larger correction begins in the market due to whatever reason, the losses to traders could be much more than usual.

For the record, YTD 2024 - Nifty50 is higher by ~3%; Bank Nifty is higher by ~1%; Nifty Midcap100 is up ~9.5%, Nifty Next 50 is higher by ~21% and Nifty Smallcap100 is higher by ~11%. Rationally speaking, the scope for correction is equal in the large cap and smallcap space that has seen sharp outperformance; and banking that has been weak even in good times. However, given the tendency of liquidity to dry fast on the first sign of correction, the potential losses (Value at Risk) are much higher in broader markets.