Devangshu Datta: On the cards: Breakout or breakdown

Last Updated: Mon, Nov 05, 2012 04:45 hrs

Investors focused on cyclical businesses often use a crude rule of thumb to identify a sweet spot. In the ideal situation, the share price rises while the price-earnings (PE) ratio drops. The interpretation is straight forward - both price and earnings are trending upwards, but earnings growth is accelerating faster than the price.

One can scale up the concept and apply it to an entire sector or indeed, an entire broad-based index. If the logic holds, India is indeed seeing the first signs of recovery in the economic cycle. In the past fortnight, the Nifty has moved up marginally, by about 0.2 per cent, and the index PE ratio has moved down marginally from 18.9 to about 18.6. Obviously, it's early days yet and the conservative investor would wait for a more marked pattern to develop. But it is an encouraging signal.

In any case, the news flow in the next week to 10 days will be much more about politics than about corporate growth. The world's two largest economies are simultaneously seeing a change of political guard and obviously, this will influence the direction of the global economy over the next several years.

In China, this will be an opaque one-party process with pundits playing many guessing games about the policy impact. This is the first time in 30 years that the PRC (People's Republic of China) is managing a political switchover while in the midst of a slowdown. It will be interesting to see how it pans out - the murder, corruption and nepotism charges that have hit the headlines suggest that there's plenty of infighting. Markets across Asia will certainly react, if there are fresh hiccups in the process.

In America of course, there is almost too much in the way of attention focussed on how a two-party process elects a president. Hurricane Sandy derailed the campaigning for a while and both candidates frantically tried to make up for lost time over the weekend.

The next week or two will see global currency volatility and probably, equity volatility as well. Wall Street put a fair amount of money into the Romney campaign and that support could translate into a surge in global equity prices, if the Republican candidate does win. The dollar has a historic trend of hardening once the election results are declared, regardless of the winner of the presidential elections. (A third of senate seats and 11 state gubernatorial elections as well as the biennial House of Representatives, or HoR elections are taking place as well). Some projections suggest a swing to Rs 55-plus is on the cards.

The US presidential election process with a popular vote and an electoral college drawn up state-by-state requires fairly sophisticated modelling from psephologists. The opinion polls suggest that the popular vote is tight to within the margin of error and hence, the election is impossible to call.

However, the popular vote aggregate is less important than the state-wise split. Psephologist Nate Silver, who was spectacularly successful in predicting the 2008 and 2010 HoR elections, uses models incorporating state-by-state polling as do several other statisticians. Silver predicts that US President Barack Obama has a 73:27 chance of winning the election because the incumbent has leads in the key "battleground states". Other state-wise break-ups also lean in Obama's favour. Romney will win traditionally Republican "red states" by overwhelmingly large margins, but that won't be enough to unseat Obama according to the Silver model. If Obama does win, the market reaction will be muted and perhaps, negative.

Coming back to India, the Reserve Bank of India (RBI) credit policy was mildly disappointing. Most traders were hoping against hope that there would be a rate cut, but not really expecting it. The increased provisioning for restructured loans for banks was a negative surprise that cancelled out the cash reserve ratio cut. RBI may cut rates in the next credit policy, but Q3 won't see debt burdens easing for India Inc.

Volumes have dropped in the past 10 sessions, but there's been little shift in institutional attitude. While foreign institutional investors have maintained their positive attitude, domestic institutional investors have remained net sellers. Retail and operators have cut back on their trading - this is normal in the Diwali period.

The banking and financial sector reacted adversely to the credit policy, but they bounced back over the next couple of sessions. It was, in effect, a false breakdown with the indices hitting lower levels for a couple of sessions, followed by a recovery to pre-credit policy levels. Technically this looks like a continuation pattern with the Nifty likely to continue its range-trading between 5,600-5,800. Actually the index seems to have significant resistance now above the 5,725 mark.

If the banking sector does breakdown, with the Bank Nifty dipping below the 11,000 mark, the public sector banks are likely to be much harder hit. They have much weaker balance sheets with higher non-performing assets and the vast majority of CDR (corporate debt restructuring) requests also involve government banks. The telecom sector has won a partial reprieve on the spectrum refarming front and this could have some positive impact on the shares of Airtel and Idea. The next financial year will not be good for any telecom operator however, and there is a good chance of litigation as well.

The chances of a breakout or breakdown in the Nifty remains high and the open interest in the Nifty option chains suggest that there are a lot of traders betting on a 300-400 point swing till either 6,100 or 5,300. I would reiterate my recommendation of deep Nifty puts till the end of the December settlement. Several events between now and the winter session of Parliament have enough potential impact to engineer a big swing. A long strangle with a deep December call and a deep December put would cover all bets without directional bias because it would be a big winner on any swing.

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