Do it yourself: VIX

Tuesday, December 24, 2024

Greed consistently dominated fear in 2024, or did it?

The sentiments of greed (risk-taking) and fear (risk-aversion) are two key factors that determine the breadth and depth of the stock market performance over a short term.

In the risk-averse phase usually themes like large cap, defensive, value, dividend yield, etc. lead the market performance. In this scenario, the market breadth is usually narrow; fewer companies raise fresh capital; volatility is low; and market breadth is consistently poor.

On the other hand, in the risk-taking phase, themes like small and midcap, growth, cyclicals, etc. lead the market performance. In an environment supporting risk-taking, usually the market breadth is strong, volumes are above average, and volatility is higher. The primary market is very active in this phase, as a larger number of entrepreneurs look to raise fresh capital for growth and deleveraging.

The year 2024, however, has seen some divergent trends. Several contradictions prevailed, which not only raise doubts about the validity of the current risk-taking phase in the conventional sense, but also present a higher probability of emergence of a severe risk-aversion phase in the near term. For example, consider the following:

· Small and midcap stocks consistently outperformed the benchmark Nifty throughout the year, despite several risk affecting events like BJP not securing majority in the general elections in India; serious escalation in the Middle East Asia geopolitics; outcome of presidential elections in the US threatening a full-scale tariff war; growth slowing materially in Europe, China and India; sticky inflation restricting global easing cycle; corporate earnings failing to meet expectations etc.

· The promoters raised over Rs three trillion through initial public offerings (IPO), qualified institutional placements (QIP), and rights issues. However, most of the QIP and rights issue money was used to deleverage the balance sheets rather than expanding capacities – usually a sign of risk-aversion. Even many of the IPOs were 'offer for sale', where the promoters diluted their stakes.

· Foreign portfolio investors have been net sellers in Indian equities in the year 2024. In the secondary market, FPIs sold over INR 1.1 trillion worth of equities in 2024. However, they bought almost a similar amount in the primary market. The share of the Indian listed market capitalization owned by FPIs fell to ~16%, the lowest level in a decade. The domestic institutional investors however purchased over INR 5.1 trillion worth of equities in the secondary market. The share of the market capitalization owned by the household investors increased to the highest level in the past 15 years.

Historically, the correlation of FPIs’ net flows and Nifty returns in a given year has been poor; but the rise of household share in stock ownership has mostly led to a risk-aversion phase in the markets.

· Despite significant outperformance of the small and midcap stocks, the market breadth and overall traded quantity has not been supportive of a risk-taking trend. In the 6 out of first 11 months of 2024, market breadth has been negative. Overall, the market breadth is neutral. The traded quantity has been mostly below average in the last six months.

· The implied volatility has been mostly moderate to low, except for a brief spike in May 2024 (election month), usually not a sign of a risk-taking phase.

Tuesday, May 7, 2024

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.