Decoding the stock market’s rally to new records

Momentum indicators suggest it will keep running up until there is adverse news flow

The stock markets hit a new high last week and continued to run up. There are many interesting aspects to this rally, which started about 13 months ago. One is the disconnect between a rising stock market and fundamentals hit by the second wave when the economy had not fully recovered from the first wave.

On the technical side, look at breadth and volume. Is the rise of the major indices (Nifty/nifty Next, Sensex) backed by similar rises in smaller stocks? If there’s breadth and volume, across all segments, there’s more confidence about sustainability.

One must also look at the participants: Are domestic institutions, foreign portfolio investors (FPIS), or retail investors doing the buying? Rallies backed by institutions tend to last longer. If it’s retail buying and big money selling, the rally may not be sustainable.

The Nifty is running at a price-to-earnings (PE) ratio of 29-30, which is historically high. But PE has declined even as the index has risen. Corporate profits have grown fast in the last two quarters thanks to a combination of cost cutting and lower interest costs. But revenues have not grown much and could decline sequentially in the first quarter of financial year 202122 (Q1FY22) versus Q4FY21, though the low base of Q1FY21 ensures YOY growth.

On the technical side, momentum indicators suggest the market will keep running up until there is adverse news flow affecting sentiment, or change in market conditions. Breadth is good. The mid-cap and small-cap indices have hit new highs more or less in coordination with large-caps. There are more advancing stocks than declining ones.

The one negative here is that retail is more bullish than institutions. In May, FPIS sold a net ~6,015 crore and DIIS bought only ~2,067 crore. Retail must have been responsible for the bulk of buying that pushed the market up.

In technical terms, you cannot set targets when stocks or indices are at a new high. Momentum players will just stay long and perhaps set stop losses to ensure they keep some profit if there’s a correction. If retail eases off buying or institutions sell more heavily, the market will correct.

On the fundamentals side, investors will discount known factors such as drop in consumption demand in April-may caused by the second wave. It’s assumed this may continue for months, until the bulk of the population is vaccinated, lockdowns ease and employment generation restarts.

Investors will also discount rising inflation — fuel, metals, and food are up. There could also be cost-push caused by higher global growth compared to India — imports (apart from fuels, which are already high) will be more expensive even if the rupee stays stable.

But Reserve Bank of India’s commitment to keeping liquidity flowing means real interest rates are low and yields from government instruments may edge into negative zone. This should induce more consumption and encourage risky investment strategy.

It will take unknown factors to tilt sentiment. This could be some black swan event that is negative, such as a terrorist attack or the discovery of some major scam. But there may also be some positive news. The monsoon could be normal, leading to a drop in food inflation and better rural demand, for example. Corrections as and when they come will be deep.