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Tuesday, October 19, 2010

What is causing the volatility in the Sensex?

Of late, the Sensex movements have become very volatile. Some times the index is opening on the plus side and moving higher during the trading day, only to plummet rapidly towards close of trading. On other days, it is opening negative and moving down further, only to regain all its losses by the end of the day.

For small investors, such trading momentum swings can be very confusing. What should one do? What is causing the Sensex volatility, and when will such volatility come to an end? The short answer to the question is: uncertainty. When the causes of uncertainty are removed, and the market is back in a clear trend (whether up or down), the volatility tends to get reduced.

Most investors take short-term views. When they are not sure what is going to happen in the near future, they tend to trade on small spreads. A few paisas of profit, and a sell order goes out. A Rupee of loss, and they try to ‘average’ (which means buying more to reduce the ‘cost’ price). The index becomes volatile as a result.

What are the causes behind the current uncertainty? There are several of them, and these have been mentioned below. Some of them have been building up over the past few months. What was the trigger that suddenly made investors conscious of these uncertainty factors? You don’t need to be an Einstein to figure out the answer. It is the ‘magic’ figure of 20000.

Many investors remember what happened when the Sensex crossed 20000 in 2008. The index crashed by 60%. Will the Sensex behave in a similar fashion in 2010? Some point out that this time it is different. It is the early stage of a bull market with the economy on the upswing. In 2008, it was the tail end of a 5 years long bull market when economic activity had reached a peak.

Others point out that unknown stocks are hitting upper circuits, just like it did in 2008. Also, the huge Coal India IPO may drain out a lot of cash from the secondary market leading to a big fall, just like the Reliance Power IPO did in 2008. (Why any one would want to invest in a notoriously corrupt PSU is another question!)

Despite the best efforts of the RBI, inflation is refusing to come under control. That could mean more interest hikes, which would be negative for the stock markets. The FII inflows continue unabated, even while the DIIs are forced to sell big time due to redemption pressures from mutual funds investors. That is causing the Rupee to appreciate against the Dollar, which in turn, is making exports less competitive pricewise.

When the FIIs started their massive selling in 2008, the Sensex had dropped like a stone. In case they start to sell again, another huge crash may ensue. Because they are not selling, there has been no decent correction in the Sensex in more than a year. So, the continuous FII buying is causing uncertainty, and the FIIs not selling is also causing uncertainty!

Last, but not the least, is the uncertainty of the Q2 results. If the results turn out to be good, the Sensex must have already ‘discounted’ it, so there is not likely to be much upside. If they turn out to be less than expectations, the Sensex may drop.

Note that some of these are short-term uncertainties. The Coal India IPO will be over soon. So will Q2 results announcements. Any interest hike may happen within the next couple of weeks. Why bother about what may or may not happen in the near future? You’ll get to know about it soon enough.

Some say that increased volatility is a warning sign of a trend change. Others say that high volatility is a sign that stocks will rally. If you really believe that the Indian economy is growing, and will continue to grow in the future (even if not at the same rate), then 20000 will just be a milestone along the way. The index is likely to reach much higher levels.

It is the short-term investor sentiments of greed and fear that is causing the uncertainty and worry – and consequently, the index volatility. Take a long-term view – which gurus like Ben Graham and Warren Buffett have advised – and stay invested.

If you want to protect your profits, set stop-losses. When a stop-loss gets hit in an individual stock, sell or book partial profits depending on your risk tolerance and asset allocation plan.

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