Sensex on the brink?

The theory of reversion to the mean suggests that the Bombay Stock Exchange Sensex should see some kind of correction soon. According to the hypothesis, the more the moving average of the Sensex shifts away from the index’s closing value as on that date, the sharper will be its drop.

We took Sensex data for the past five years and plotted the difference between the 50-day moving average and the index itself. The chart indicates that this difference was at its highest, at approximately 1,250 points, when the Sensex peaked on May 10, 2006. The decline was steep from there, with 3,683 points getting shaved off the index in just 25 trading sessions.

In the last five years, there hasn’t been such a large gap between the moving average of the index and its closing value. Which brings us to more recent weeks. Since mid-August 2006, there have been four days when the difference has been over 1,000 points, including last Thursday, when it was 1,005 points. Technical analysts are a tad worried, because if one discounts May, 2006, the difference has never been so large.

Recent data also indicate that foreign institutional investors (FIIs) have been buying in the cash market and selling futures. In September, they have been net buyers by Rs 3,691 crore in the former and net sellers by Rs 3,413 crore in the latter. But analysts say that this cash market buying could be a temporary phenomenon, since they seem to be using these stockmarket operations to short the dollar against the rupee by proxy in the belief that the rupee will strengthen. If this latter trend reverses, the FIIs could change tack as well.

Don’t count Reddy out

Predicting interest rates is a risky business but that doesn’t stop experts from take a shot at it. After 17 consecutive raises, Ben Bernanke’s US Fed has stopped at 5.25% and the widely held view these days is that the rates won’t go up any further.

The latest meeting of the Federal Open Market Committee observed: “The slowdown in the housing market, the effects of higher energy prices on household purchasing power, the waning impetus of household wealth effects on consumer spending, and the effects of past policy tightening were expected to hold economic growth below potential over the next six quarters.”

Given this, the consensus interest rates for the US for 2007 have been revised to 2.7% for 2007 as against the earlier 3.1%. Hence, it’s highly unlikely that interest rates will be raised any further in the American context.

Does that hold good for India, too? A certain section of experts feels that interest rates have peaked, and there is no scope for more hikes. The primary reason being put forward is that it will be very difficult for Reserve Bank governor YV Reddy to raise rates when other central banks aren’t doing so. Further, with the appreciation of the rupee by 2% in the last two months and the fall in oil prices, inflation fears stand reduced.

But another school of thought says that credit continues to grow fast even after rate hikes, and this could be a danger signal for inflation. A Standard Chartered report on emerging markets says that the “brisk pace of economic activity, rising money supply (19.4% in early September), and the 22nd month of 30% plus credit expansion suggests that inflation pressures are building.”

It expects the RBI to raise reverse repo rates in October by 0.25% to 6.25% “to keep inflation under check”. The markets, which have been celebrating the end of rate hikes for sometime now, have good reason to worry.

Contributed by Sanat Vallikappen & Pallavi Pengonda