Is this a false rally?

Last Updated: Mon, Sep 09, 2013 05:12 hrs

One of the biggest behavioural issues for a trader is confirmation bias. This is a form of selective blindness. Evidence contrary to the trader's views is ignored. In most market situations, there are positive and negative factors to consider and it's difficult to know which ones deserve the most weight in a given case.

Somebody with a confirmation bias has huge problems coping with shifts in trends. For example, the trader might believe the market would go up (or down). He can see evidence in favour of his belief and he cites that evidence. If he has a a confirmation bias, he ignores that, instead of weighing it appropriately before making decisions.

Confirmation bias is a broader problem as well and it affects our decision-making adversely in many walks of life. But the impact on a trader's life is very sharp and immediate. When you are wrong, you lose money.

Right now, traders need to weigh certain conflicting variables. The market has been bearish for a while and the reasons are evident. The domestic economy is in poor shape, corporate earnings have dropped and there are large macroeconomic problems. In addition, the external global situation makes it likely that India will not receive much investment in the near term. The fundamentals have deteriorated over a period of three years; they will not be put right in a quarter or even within a financial year.

However, these things are known. They may have been discounted to a certain extent. There has been some improvement in sentiment after Raghuram Rajan took charge as RBI governor last week. We saw a similar turnaround in sentiment when P Chidambaram took over the finance portfolio on July 31, 2012. It's interesting to compare the situations.

At the time Chidambaram took over, the Nifty was trading at 5,200-5,300, just as it was when Rajan took charge. The post-Chidambaram rally pulled the market up by 20 per cent over a 10-month period, before the current bearish trend took over in June 2013. Could Rajan's appointment trigger a similar rally? Let me list some reasons for why it might and some for why it might not.

The market has bounced several times from the Nifty 5,120-5,250 zone. It appears a certain amount of buying comes in at those levels. This happened in 2012 and again in the last fortnight. The Chidambaram rally was premature and irrational in retrospect. But it lasted 10 months. As Keynes once reputedly said, the market can stay irrational longer than a trader stays solvent.

On the other hand, September 2012 saw the launch of Quantitative Expansion-3 (QE3), when the US Federal Reserve decided to pump an excess $85 billion of liquidity into the market. Enough of that money came to India. In fact, the Nifty was down to 4,900 before QE3 came to the rescue. As things stand, Rajan may have to deal with that money flowing out.

A possible alternative source of foreign investment is hawala money. Hawala flows will come into India over the next nine months and more to fund election campaigns. Some of it will be routed through the stock market and it could provide a counter-balance. It's impossible to assess the possible impact but it is worth bearing this in mind.

The other thing is domestic sentiment. After Chidambaram took charge, there was a brief period when locals believed things would improve. Those hopes were belied but Rajan's appointment and his opening speech could have sparked similar feelings.

Looking at things another way, equity prices are eight-nine per cent higher than 12 months ago, though the fundamentals are worse. Markets tend to rally in anticipation of a better future. This means many false rallies. But those false rallies can last long enough and go high enough to wipe out a short-seller. Eventually, there will be a sustainable rally.

I think this is a false rally but I would hate to be suffering from confirmation bias.

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