Riding Choppy Waters

Volatility, it has been said, is a car with two pedals: the brake pedal is fear, and the accelerator is greed. Both are the principal drivers of the stockmarkets. The uncertainty of the past six weeks has enhanced market volatility. All you have to do is look at the swings, both intra-day and intra-week. On Tuesday, 10 November for example, the Bombay Stock Exchange (BSE) Sensitive Index (Sensex) swung between 16371 and 16677 during the day. In the four preceding trading days, the market had risen by just over 7 per cent (see ‘Mood Swings').

It is the first-of-a-kind for everyone. Intra-day volatility is becoming a way of life in the equity markets, and bond markets too. Quite often, the sentiment when the market opens is vastly different because brokerage firms have made some recommendations, which subsequently may have proved to be misleading, even wrong.

Dhirendra Kumar, head of Value Research in New Delhi, points out that when the market rebound began about four months ago, most fund managers — especially the domestic ones — kept waiting on the sidelines.
When they rushed in, the market zoomed even higher with all the excess liquidity. Then came the Reserve Bank of India's monetary policy review that suggested the beginning of an exit policy. Fears of a liquidity squeeze then drove the market down.

"Few fundamentals have improved sufficiently to stabilise the market," says a fund manager who wished to remain anonymous. "More importantly, the cycles are becoming shorter, which indicates a long-term trend of increasing volatility. Ten years ago, the bear cycles would typically last four or five years. Then it came down to two years or so. The current cycle was just for a few months..."



Where the volatility is scary is looking at the size of the ups and downs; keeping up a 250- point increase day after day for a week is making people begin to wonder. Is the rally for real, as so many are beginning to say, or is it a phase with a big correction three months or so down the line? And for investors, making investment decisions just gets harder with greater volatility — not just here, but the world over.

Where Is It Coming From?
From March to September this year, the stockmarket indices have risen by anywhere between 25 per cent and 80 per cent across the globe. The 30-stock BSE Sensex has registered the highest rise, a growth rate that was about 60 per cent higher than the next highest rise seen in Brazil's Bovespa index.

Let us not forget that a year earlier, in 2008, the same Sensex fell 63 per cent from its all-time peak of 21206 in January to a three-year low of 7697 in October. But as the Sensex gained steam from March this year, a sort of amnesia seems to have set in. So when the Sensex fell by nearly 11 per cent from mid-October to early November, there was some panic. Since then, of course, the Sensex has recovered — with a couple of hiccups — to end the week at nearly 16849 on 13 November.

Many believe the aforementioned 11 per cent crash — and similar falls in other stockmarkets around the world — had to happen sooner or later, although they find it difficult to explain the quick sharp recovery thereafter. "After the steep rise in the past six months, the markets had to take a breather," says Raj Bhatt, chairman and chief executive officer (CEO) of London-based Elara Capital, a member of the London Stock Exchange.

Another reason for the recent jump in volatility comes from central banks' assertions about the need for an exit strategy from all that cash sloshing around; the liquidity that has driven markets to their present heights despite the absence of any good economic news or fundamental improvements or shifts in economic performance. Markets were quickly reassured that any withdrawal would be gradual, after which they went back to climbing higher. But how much of the volatility is real?

Imported And Other Volatilities
"Volatility comes from three sources, by and large," says D.D. Sharma, head of research at Anand Rathi Securities, a brokerage firm. "There could be a huge divergence in the views of market participants, and it is highest when the market is at a crossroads, as it appears to have been recently." And when volatility is high, it also portends a turning point, just that no one knows which way.

What markets are dealing with may not be one, but a combination of volatilities. Broadly speaking, there are three kinds of volatility at play: open-gap volatility, associated with the gap between the previous day's market closing and opening of the following day, intra-day volatility, when the index swings depending on various developments, and stock-level volatility.

"Open-gap volatility is something no one can manage," says Rashesh Shah, chairman and CEO of Edelweiss Capital, a financial services firm in Mumbai. "But much of that seems to have quietened down here. The gaps are getting narrower these days." Last November, this overnight price risk was managed by writing options at high premiums; for those who buy the options, intra-day volatility gives them the chance to liquidate or reverse their positions.

Intra-day volatility is a lot easier to manage. In recent weeks, options have become the preferred choice — compared to futures, for instance — for people seeking to hedge their bets. More options contracts are traded than futures contracts. A good indicator of volatility here is the put-call ratio; a number greater than one is usually indicative of caution.

While the options market has the tools to manage stock volatility for traders, it is all about portfolio allocations for investors. "As an asset class, stocks are exceptionally volatile, and despite historical data suggesting that stocks can get you better annual return over the long term compared to other asset classes, two-three years of dismal performance could set you back far behind where you wanted to be," says a financial planner who did not wish to be named. "Dealing with volatility must be a factor in portfolio and retirement planning."

Miracle Versus Mirage
Most market participants, securities firms and broking houses contend that volatility has actually declined over the year. In other words, they believe that perceptions of increased volatility may be exaggerated. They just point to the popular volatility indicators to make their case.

The most widely used measure of volatility is the Volatility Index (VIX) of the Chicago Board Options Exchange (CBOE). A number over 30 implies high risk (from volatility) and below 20 suggests stability. After having risen to an unprecedented 80 after the Lehman Brothers collapse last November, it stayed in the higher range above 30 for most of the first half of this calendar year, till May (see ‘Fear Index').

"From an average of over 32, the VIX has fallen to levels of 22-23, though it may be inching up a little to 27-28," says Sandeep Tandon, managing director and CEO of Quant Capital, a large institutional broking firm based in Mumbai. "Capital flows — which have been around $17 billion — are steady, so volatility is likely to stay low."

Bhatt echoes that point, underscoring the liquidity effect of lowering volatility. But he also acknowledges what sceptics have been saying: "Stocks have essentially gone one way but the real economy — which is at the end of the day underpinned by consumer spending, which in turn is underpinned by jobs and expected job security — is lagging."

Besides the VIX, there were other technical pointers, such as options ratios. The put-call ratios on index options traded at the Chicago Mercantile Exchange — higher ratios meant cautious traders were hedging their positions — were rising sharply above the mean of 1.2 from 1 January this year to 25 August. It started crossing 2 on some days and was sustaining above 1.5 on most days till mid-October when the global markets began their sudden slide.

On the National Stock Exchange (NSE) in Mumbai, the S&P CNX Nifty options put-call ratio was below 1 for most of July and August. But in September and October, before the mid-October crash, that ratio went above 1, clearly indicating that normally bullish domestic traders were becoming wary. The large options positions have also arrested the market's decline. But how long can that stability be sustained?

Hyper-Reactivity
Indian market indices, along with those in China and Brazil, have generally tended to over-react to global news and fund flows on both the upside and the downside. Global cues, as they are commonly referred to, have been volatile too. "A 1 per cent change often has a much larger effect on a market that is not very deep," says V.R. Srinivasan, CEO of Brics Securities in Mumbai. "We are getting a mixed set of signals from overseas." And sometimes, domestic factors add to the churn.

"The late October fall was a knee-jerk reaction to the RBI monetary policy review which indicated a reversal of the easy money policy, raising fears that an interest rate increase would stall the economic growth," says Sarabjit Kour Nangra, vice-president, research, at Angel Broking, a Mumbai-based brokerage. She expects the volatility in the markets to remain high as the news on earnings and global recovery play themselves out in the next six months.

Additionally, there was a contraction in flows to equity markets worldwide in the second half of October and the Indian market was not spared (see ‘Foreign Influence' on page 40). "We all know that markets in India have always been greatly influenced by foreign fund flows," says Dipen Shah, senior vice-president, private client group, at Kotak Securities. "These, in turn, depend on a confluence of factors such as attractiveness of markets in terms of growth and valuations, alternate asset plays and exchange rates."

There are other obvious reasons, such as corporate fundamentals. "If the outlook for earnings growth of Indian companies looks bad, less foreign money will come in," says Ajay Shah, senior fellow at National Institute of Public Finance and Policy. Second-quarter corporate results have been slightly disappointing, to say the least, after first quarter results promised a faster bounce back.  

From The Outside, Looking In..
So what is the prognosis for future volatility? "All the domestic factors that could be accounted for have all been played out," says Srinivasan of Brics Securities. "It is only the overseas calculus that could impact volatility now." Many see the Indian markets as still being slightly overvalued, and anticipate a correction — though no one is clear how big it will be — in the next three months or so.

If liquidity is the element that will keep volatility under control, then there may not be much to worry about. In the last quarter of the financial year, life insurance companies and mutual funds raise a lot of money. Estimates put the total potential amounts over the equivalent of $11 billion. This is separate from a couple of billion dollars capital inflows which came through foreign institutional investors (FIIs).

But the picture is not exactly clear. "For instance, the index of industrial production numbers came out on the high side, but the markets did not get particularly excited," says Shah of Edelweiss. "But international signals will matter. Exit policies by other central banks may end up tightening liquidity, so that will have to be watched." Government announcements — on disinvestment plans or reforms, for instance — could also have a salutary effect in blunting volatility.



The biggest threat, of course, is the timing and extent of the exit policies of various central banks. As RBI Governor D. Subbarao indicated in the monetary policy review at end-October, India might take measures ahead of other markets. Australia has already raised rates twice, and the Korean central bank has tightened interest rates. In the end, however, it might come down to the basics: economic performance, both in the developed economies, and here.

IMPOSSIBLE SCENARIOS

To paraphrase what former US Defence Secretary Donald Rumsfeld said, there are things that we don't know that we don't know. In that vein, the market doesn't know what it doesn't know. Despite the enormous amounts of liquidity floating around, the vulnerability of markets to volatility is higher than it has ever been. "This kind of volatility is unprecedented, and across years," says Motilal Oswal, chairman of Motilal Oswal Financial Services. "It was extreme in 2007 on the upside, then fell to an extreme on the downside in 2008, and appears to be hitting another extreme on the upside again. I have never seen anything like this in my lifetime." Some extreme scenarios have been forwarded. Here is one: there are fears of a sovereign default by Japan, of all countries. Why? Japan's fiscal position is one of the worst in the world with a deficit of over 10 per cent of gross domestic product (GDP) and a debt-to-GDP ratio of over 200 per cent. Combine that with an ageing population and the implications for other debt-burdened countries can be serious. If interest rates rose, there will be more sovereign defaults converting the global financial crisis into a global credit crisis. That is not all; other scary scenarios abound. On the other side of the world from Japan, a weak US dollar and potential growth in oil demand could trigger another swift jump in oil prices to over $100 a barrel. Further, dollar weakness could drive capital to emerging markets, especially to China, and start another asset bubble spiral, including in real estate. In the shadows sits the expectation of a W-shaped recovery, meaning the developed world, mainly the US and the UK, could take another hit.This will lead to more stimulus packages, continued low interest rates, and even more global liquidity. You can almost hear the cry: Stop the world, I want to get off!

...And From The Inside, Looking Out
There is a consensus that global economic recovery is largely dependant on growth in consumption in the US as well as the ability of China to sustain its economic growth. There is, however, mixed opinion about how it will pan out in the next six months. "The most important economic driver globally is fall in unemployment," says Elara's Bhatt. "If employment picks up in the US and Europe, it will spur demand in consumption and lead to a sustainable rally in the financial markets."

British economists are not so confident of that happening in the UK. Royal Bank of Scotland's London-based chief economist, Andrew McLaughlin, stated in a recent weekly brief that the UK economy confounded expectations by contracting for a sixth consecutive quarter, "making the current recession the longest in the country's post-war history. The cumulative contradiction in output now stands at 6 per cent, on a par with the decline seen in the early 1980s".

Recent Chinese economic data points to a strong growth in heavy industrial production, largely on account of infrastructure spending, but Asia-tracking economists are not fully convinced the overall economy in China is growing in a balanced manner. China's stockmarket index, Shanghai Composite, has been the most wildly gyrating of all global indices.

The Gloss On Things
The Indian story, on the other hand, has many more cheerleaders than detractors. A new research report by India Infoline titled ‘INCH (India-China) — The Emerging Financial Super Power' states while Chinese economic growth will continue to be strong before it moderates, "the opportunity in India seems to be under-exploited at this stage".

Expecting Indian listed companies' annualised medium-term growth outlook to be 15-20 per cent, a recent ‘India Equity Strategy' report by Prabhudhas Lilladher's chief equity strategist, Carlos Asilis, states that the Indian equity market, "on a prospective total return basis, entails the potential for annualised return performance in the vicinity of 15-20 per cent in rupee terms, and 20-25 per cent in US dollar terms over the next 5-10 year horizon."

But no one is certain that such growth rates are assured, at least in the next 6-12 months. There is the spectre of rising inflation that cannot be wished away. "Besides inflation, the most worrisome factor for the markets in the next few months could be the bank credit growth's stagnation," says Dipankar Mitra, head of economic and country research at Noble Group India. "It is in single digits, and a recent fortnight in October even saw a negative credit growth, very rare for this time of the year as it is usually seen in end-March or in April."

Most economists agree that without a sound credit growth, the double-digit growth in industrial production is unlikely to be sustained and, consequently, stockmarket fundamentals will not present a rosy picture. There are other significant factors as well, such as the hitherto non-deflatable real estate bubble.

Riding Out The Storm
Like everything about the financial markets, volatility is traded too. In fact some traders try to actively make money on volatility, often using the same options strategies that the more cautious use to hedge their bets. "You could buy more of the stocks that you own that go up, and sell those that are going down," says a day trader who requested anonymity. "You ride the winners and sell the losers." That is going ‘long' on volatility.

So what are expectations about volatility? "We expect it to continue across markets because of the still hazy macro scene," says Kotak Securities' Shah. "In our opinion, the Nifty will oscillate in a range of 300-500 points till next quarter results and that will be desirable." Shah is, however, apprehensive that there may be periodic excesses beyond this range.

Does that imply that fears of a large correction are justified? "There is always an inherent potential for a 10 per cent correction in any market," says the head of a leading financial services company. "Yes, there could be a correction in the next few months, but it is not something you can time."

Today's uncertain market environment appears to reflect both the wisdom of crowds and the herd phenomenon. Sharma of Anand Rathi Securities says that volatility is a natural market phenomenon, neither good nor bad. Behavioural economics research has shown that individuals, who make their own independent estimates, uninfluenced by each other or by a common theory, tend to on average produce very accurate estimates. That is the way to survive volatility, and perhaps profit from it.
 
srikanth dot srinivas at abp dot in

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