Just when the bulls were thinking that they'd never had it so good Securities and Exchange Board of India rained on their parade. The market crashed the instant the participatory note-related proposals were released. Even after digesting clarifications from the regulator, the market has continued to slide.

The near-term prognosis isn't good. For the last three years, the Indian stock market has ridden to successive highs on a tsunami of forex inflows. A large proportion of that is through participatory notes. A lot of that money will flow out in the short run.

Some may flow back in through other routes. But the new PN-regulations will certainly cause a sharp correction and, it is possible, that it could trigger a serious bear-market where stock prices correct over 20 per cent and stay down for over a quarter.

In the following paragraphs, we look at some of the key factors traders must consider: 

The FII-FI divide

There is an obvious difference in attitude between foreign institutional investors and domestic funds. Between April 1 and October 17, FIIs were net buyers of Rs 63,800 crore (roughly $16 billion) while the domestic funds were net buyers of just Rs 2,840 crore (Rs 28.4 billion).

Post-July, FIIs have bought Rs 45,865 crore ($11.5 billion) while the Indian funds have sold a net Rs 521 crore (Rs 5.21 billion).

Since April 2007, the Defty, which tracks dollar-denominated Nifty returns, has risen 52 per cent while the Nifty has gone up 40 per cent. Since July, the Defty-Nifty combination has risen 27 per cent and 24 per cent respectively.

The statistics suggest FIIs are entirely responsible for this bull run. They are major players on the spot market. In the derivatives segment, their dominance is absolute. They hold around 35 per cent of all outstanding futures and options positions at any instant. 

Dollar premium

The premium of the Defty's return over the Nifty is one clue to the reasons underlying differences in institutional attitude. The rupee's uptrend has led to more dollars pouring into Indian assets. Yet another difference is due to interest rate differentials.

The rupee 364-day treasury bill is at a yield-to-maturity of 7.4 per cent while the US treasury bill is offering a yield of just under 4 per cent. For Indian investors, the Nifty trading at a PE of 24-plus is over-valued. For an FII, the same valuation of 24 is acceptable since US interest rates are much lower. 
 
The PN factor

The FII attitude changed on Wednesday when Sebi's proposals on the phasing out of PNs were released. Between Tuesday's close and Friday's, the Nifty has lost about 8 per cent and experienced wild 500-point gyrations.

The regulations will come into effect post-settlement (October 25). A large number of PN positions must be unwound. PN F&O positions can be carried over for up to 18 months but new PN derivative positions can't be opened. In spot markets, PNs of up to a limit of 40 per cent of assets under custody can continue to be held.

We don't know exactly how much FII spot market investment has come through PNs and specifically through the targeted sub-account PNs. In this fiscal, estimates are about 50 per cent of all inflows.

In toto, about $88 billion of the estimated $220 billion worth of total FII assets under custody is believed to be PN-related. Some of this money must unwind.

Sebi says the equivalent of $30 billion worth of PNs is parked in F&Os and that money must unwind. The carryover in this derivatives settlement would offer some clues about whether it will leave in a hurry or do a leisurely round trip inside that 18-month deadline.

From a trader's perspective, it's enough to know that a lot of liquidity could be lost, either immediately or over the next 18 months. Obviously there will be an exaggerated effect on counters where PN-funded positions are high.

Technical projections

How much liquidity will PN-exits remove from Indian bourses? While the effect must be bearish, how deep can the correction go? 

We don't have an answer to the first question except that it will be a substantial amount. It would be conservative to assume that between $2-3 billion (Rs 8,000 crore to Rs 12,000 crore) could exit the spot market in the near term.

Technical calculations suggest that the market could fall by up to another 1,200 Nifty points within the next three to five months. It is nearly certain to fall another 500-750 points. The reasons for these bearish guesstimates follow.

FII versus FI

There are several reasons why Sebi's move could trigger a bear market. Obviously, when hot money moves out, some long-term funds exit with it. Players sitting on profits will sell to lock that in. Also, it's Q4 of the financial year for FIIs.

The temptation to book profits will be high. Substantial FII outflows would lead to rupee weakening. This may make a positive difference in export-oriented sectors such as IT and pharma. But it would also remove a cushion for dollar-investors in terms of Defty return premiums.

The cash position of domestic funds is tight -- Indian diversified equity funds held less than 6 per cent in cash assets at end-September. They cannot absorb the sort of selling pressure a mass FII exodus will create. Insurers are an unknown factor. They hold an unknown cash corpus raised as ULIP premiums. But insurers and mutual funds combined still cannot match FII money-power.

Political uncertainty

Another bearish variable is political uncertainty, here and in the US. The nuclear deal appears to have fallen through and it might trigger an early general election in India. If that happens, domestic funds and retail traders will join the exit parade. The US is heading into presidential elections in 2008 so FIIs face uncertainty at home as well.

Fundamental strength

To balance all that, the economy is chugging along. Thus far, Q2 results don't indicate slowdown beyond expected levels. If valuations drop, FIIs may be tempted to re-enter on the valuation factor alone. High rates of GDP growth can be taken for granted. At current dollar interest rates, FIIs may decide a market P/E of say, 20 is an excellent long-term holding.

Correction calculations

It's difficult to build technical scenarios. The market has hit a rapid succession of new highs and we have little trading history at current levels. The best tool for judging corrections is Fibonacci analysis.

This allows us to calculate probable corrections levels in terms of the last uptrend and also gives some indicators about timeframes. We can refine Fibonacci calculations with a look at support-resistance levels and previous trading patterns.

The last significant bottom came in June 2006 at about Nifty 2595. On Thursday, the Nifty hit an intra-day high of 5736. That is, in just under 16 months, the major market index has risen 121 per cent with an upmove of 3141 Nifty points.

The key Fibonacci levels are roughly around 5000, 4550 and 4165 where there are also significant support levels on chart patterns. The market has bounced once from around 5100-levels and a drop to 5000 is almost given.

A further 10 per cent drop to the 4550 levels looks extremely likely in the near term that is, within the next two-three months. If there is a cascading effect with "cold" money flowing out along with the hot, the 4165 level of 50 per cent retracement of the entire upmove is not unlikely.

A correction to 4165 level would be about 27 per cent down from the all-time high of 5736. Last year, between May 2006 and June 2006, the market moved down 31 per cent from the then-all-time high of 3775 to a low of 2595 in the space of just five weeks. In that time-span, the FIIs were net sellers to the tune of Rs 6,800 crore.

So if our assumption that a minimum of Rs 8,000 crore (Rs 80 billion) will be pulled out is accurate, a drop of 27 per cent is very possible. Anything over 20 per cent correction qualifies as a bear market. However any bear market where the bottom comes above or near the support of the 200-day moving average is unlikely to be very severe.

The 200 DMA is now hovering at around 4300 -- the market has moved up so astoundingly fast, this long-term benchmark lags price considerably. Since the 200 DMA will dip with the downtrend, it is quite likely to be down till about 4165 if and when the Nifty corrects to that level.

So it is perfectly possible that the bear market will find support at either 4165 or 4550 and turn around. However if the 200 DMA is clearly breached, the market would fall till at least 3750 levels.

Sensitive stocks

The impact of PN exits is likely to be skewed and stock-specific. Certain stocks such as Indiabulls [Get Quote] Financial, Indiabulls Real Estate [Get Quote], HDFC [Get Quote], Axis Bank, Jindal Steel & Power, IDFC [Get Quote] and PNB feature outstanding PN positions in excess of 10 per cent of respective total equity.

Obviously such stocks will be more vulnerable. The effect has so far, been uneven. Of the top ten in terms of PN holdings, Axis Bank, HDFC and Nicholas have seen support come in. The others have been hit much harder than the overall market. Any trader looking for potential short future positions should trawl the list of PN-sensitive counters. 
 
Conclusion

If our assumptions are close, expect the market to move down by between 10-20 per cent in the next three to five months. This may happen at accelerated pace or it may be staggered and mitigated by round-tripping if PN funds exit and re-enter through the 40 per cent assets under custody loophole. Technically, one would be worried if the 200 DMA is broken -- the market will need to dip below 4100 for that to occur.

Political considerations may put a brake on a big recovery until the general elections are over. Elections must happen by May 2009 and the PN unwinding must finish by April 2009. It will be most entertaining when the two events overlap.

Liquidity in the F&O segment will be adversely affected. Daily trading volumes in F&O would drop by at least 20 per cent once the PN money is out. There could be a 50 per cent dip in market-wide open interest. Margins on futures positions will rise. It will be more difficult to find counter-parties and create option-based positions.

Until it's all over, the trader's bias should be on finding short positions because the overall trend will be negative. Of course, there will be isolated winners and periods of recovery within this pattern of net losses. Mid-caps and F&O counters with low PN/FII exposure will have better defensive strength.