8000 listed companies, only 20 active stocks

The abysmal Indian Olympic performance has parallels with performances in the Indian stock market. In the one field, you have one billion individuals and one bronze medal. In the other, you have 8,000 listed companies and just about 20 active performers.

In fact, it's been infotech, communication and entertainment (ICE) all the way for the last two years. Something like 90 per cent of all trading volumes, (which have hit record levels), are logged by just 10-15 companies. Almost all of them are new economy counters.

This leads to interesting statistical paradoxes and some interesting conclusions for both traders and long-term players. One can also come to very provocative conclusion on the basis of the evidence!

Let's enumerate one of the biggest paradoxes. The Business Standard ICE Index moves up 350 per cent between November 1999 and February 2000. The Sensex moves up "just" 37 per cent. Then the ICE index bottoms 59 per cent down in the next seven months, while the Sensex loses 38 per cent. The Sensex is now trading below its November opening levels of 4490 while the ICE index is still up 80 per cent.

How is this possible if ICE captures 90 per cent of trading interest? Primarily, because the Sensex doesn't recognise this factor. ICE is represented here by only Infosys, Satyam, NIIT and Zee. So a big ICE-based move is under-represented in the index.

Also, the Sensex calculation is based on market cap, so it doesn't recognise trading volumes. Thus, a move in Hindustan Lever will influence the Sensex more than a move in Satyam although Lever may trade at a quarter of Satyam's daily volumes.

When making index-based trading decisions, this is an important point to bear in mind. It is extremely important to recall this factor in the case of a company like Wipro where the share is thinly traded due to the huge promoter holdings. Wipro swings the BSE-100 disproportionately for this reason.

The second paradox is not really a paradox as much as a fallacy in perception. ICE does have a very high correlation with the one-session lagged Nasdaq-100. It moves in the same direction eight sessions out of ten.

But ICE now has an even higher correlation with the Sensex of the same date. So don't supersede the Sensex trend and bet on the Nasdaq trend blindly. The reason for rising Sensex correlation is that most ICE trading is done by Indian operators and not by foreign institutional investors. Almost 90 per cent of ICE trading is settled without delivery and should really be viewed as short-term intra-settlement futures plays rather than equity trades.

Another factor is the incredibly high correlation between individual ICE stocks. When a diversified market index such as the Sensex or the Nifty moves up, it is quite possible that much of the constituent population is actually moving in the opposite direction.

This is often the rule rather than the exception with a widely diversified index. The Sensex can be decomposed down into a small population of key positive-beta movers such as Infosys, Reliance, Levers, ITC, Satyam and Zee.

If these six move in one direction, the other 24 stocks could be negative beta and the Sensex would be misleading in reflecting the general trend.

The case is entirely different in the ICE index, presumably because it is not very diversified. It is very rare for a large population of ICE stocks to diverge from the general index movement. Every ICE stock has a positive beta compared to the ICE Index.

Which means that any three ICE index stocks, say Infosys for IT, Himachal Futuristic for communication and Zee for entertainment, will capture the direction of the index. This has obvious trading implications. Since all betas are positive, you can narrow down to the highest beta elements and take a futures bet on them confidently when you have diagnosed the ICE trend.

All these have strong implications for the short-term trader. The philosophical implications for the long-term investor are very interesting too. Some big questions arise. Before dealing with them, let's summarise the above.

One is that the Sensex seems extremely unlikely to move in the opposite direction as the ICE Index - that is the ICE index is positively correlated with regard to the rest of the market. Another is that ICE is very high beta in comparison to the Sensex. The third is that only 10 per cent of market volumes are generated in non-ICE stocks. Volumes have declined in other market segments and so has volatility.

Now, should the long-term investor want to touch non-ICE stocks at all? Can he bet on fast moving consumer goods and pharma for example, and hope to get a return better than and independent of ICE-movements? Does this mean that all old-economy valuation models based on manufacturing and financial industry paradigms must be replaced by whatever valuation models are currently popular for ICE?

A passive investor can replace his diversified Sensex holdings with a narrow portfolio of high-beta ICE stocks. If the market will give good returns over the long-term to the passive investor, a narrow ICE portfolio will outperform. If real protection from diversification is unlikely, why bother?

This situation may not hold for the long-term but the definition of long-term would be very long. The ideal holding period for an Indian portfolio appears to be about seven years if one refers to Dr L C Gupta's benchmark study on P/Es for the BSE. That is the period when the reward to risk equation is traditionally highest.

Well, the situation of outperforming positively correlated ICE stocks has held now for over two years. It could hold for the next 5 since the macro-projections about growth seem to remain the same for both the general economy and for ICE.

So if somebody looks for Non-ICE performers, they are being contrarian by definition. The volumes will be comparatively thin, the stocks will underperform (which may not be a bad thing if the market is bearish), and returns will only come in the very long-term.

None of this fits with the normal investor profile - thus few mutual fund managers will do it. The Templeton funds could be an honourable exception - and Templeton's low returns are a clear pointer to the risks involved.

Going outside ICE has actually become a high-risk contrarian bet. If you are determined to do this, you should probably carry it a step further and look for small stocks that are completely outside the fund managers' universe.

That way, you may pick up multi-baggers. Don't touch big non-ICE stocks in the next four-five years! This seems a provocative conclusion but a logical one.

Devangshu Datta

Money

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