US stock markets arguably have benefitted from the ‘Greenspan Put’ and later the ‘Bernanke Put’. The narrative being that if there was ever a stress in the economy or any economic event which would have triggered a market crisis, Greenspan(Chairman of US Federal Reserve 1987 to 2006) would cut interest rate and flush markets with liquidity so as to ensure that the markets did not crash. ‘Put’ refers to a Put option where the put option buyer has the right to sell an asset at a pre-determined price to the put option seller even if the price of the asset has fallen significantly below pre-determined price level. Continued with the narrative of Greenspan Put, the market assumed that they own a put option from US Federal Reserve and was thus not worried about economic crisis or sharp market corrections knowing that they will be bailed out.
Indian retail investors’ participation in the equity market has increased sharply post January 2014 and this may hold Indian equity prices at elevated level providing exit to smart money such as Foreign Institutional Investors (FII) and other bulge bracket investors and proprietary traders. Indian retail investors have been participating through SIP of Mutual Funds (MF), Employees Provided Fund Organization (EPFO) and National Pension System (NPS). This steady source of domestic liquidity, funded by retail savings may be providing a de facto put option to other investors and may be instrumental in supporting historically high market levels. The current Nifty Price-earnings (P/E) ratio is around 24X. Comparable, though slightly higher P/E ratio was observed between October and December 2007, and similarly in 2000. In each of these instances the market corrected sharply afterwards. Currently, with corporate earnings surprising more on the downside it’s anybody’s guess as to how long the current bull run may continue. As such, examples of elevated market levels supported by liquidity are not rare at all. But in this case, the provider of the put option to the smart money i.e. the Indian retail investor may be blissfully unaware of the elevated risk levels
I study the FII and MF purchase dynamics with Nifty Level historically and focus on the period post Jan 2014 to highlight the risk that domestic investors face. As such higher domestic participation in equity market as well as lesser dependency on foreign investors by itself are not bad. The timing of when this transition is happening and the limited knowledge of retail investor with respect to the risk they are taking are the issues which may provide a shock to retail investors and thus reduce their confidence on Indian equities. This may not help in development of Indian equity markets.
Dynamics of FII and MF Investments in Indian Equities
Prior to Jan 2014, Indian equity markets were largely driven by FII inflows/outflows. To study the dynamics I consider monthly Net Purchase, with negative value implying net sales. The net purchases are cumulated at various time points such as January 2001.The cumulative figure at any point in time does not represent the total purchase or investment in Equity. They represent the total incremental equity purchase (or sell if the value is negative) from the time point where accumulation started.
From January 2001(Nifty:1316) cumulative net purchases of MF peaked in June 2009(Nifty:4436) and measured at INR39,000 crore. The commensurate number for FII was INR207,000 crore. Clearly the key driver of Indian equity markets during this phase was FII. Most of the incremental purchases that happened in MF during the eight and a half years got pulled out between June 2009 and January 2014. During this period Indian MF had Net Sales of INR 35,000 crore. Between June 2009 and January 2014 the FII pumped another INR437,000 crore(Cumulatively INR 640,000 crore from January 2001)
Analyzing the monthly net purchase data suggests that for most of the period the FIIs and MFs may have been taking an opposite view of Indian’s market. Correlations run on Net Purchase(monthly) between FII and MF for various rolling/trailing periods( 6 months, 12 months, 24 Months and 36 Months) are mostly negative. The highest negative correlations are for 6month trailing periods. Of course FIIs compare India with a basket of other countries and Indian equities’ attractiveness at any point in time would depend among other things on their relative expensiveness/cheapness with respect to other countries
A simplistic explanation for the negative correlation between purchases of MF and purchases of FII is that if Indian equity rises, the FII limits investment (instances of large pull outs has been limited) while the MF , which attracts retail investment because of recent performance(driven by FII investment), invests creating a negative correlation. Prior to January 2014 , MF has seen period of significant redemptions(June 2009 to January 2014) where the Net Purchase(monthly) has been usually negative. Also there were periods where cumulative purchases wavered around approximately fixed levels because of fidgety retail investors ie the Net MF purchase altering between positive and negative values in alternate time frames.
What Happened Post January 2014?
In January 2014, The Nifty P/E ratio was approximately 18.5, somewhere around the long term average, possibly with a slight upward bias. Nifty was at 6000. In the last 36 months, MF have made incremental net purchases of INR 260,000 crore while FII have made purchases of INR I76,000 crore. Currently the Nifty is around 10,500 and P/E is at 24.0. In fact from February 2016(Nifty:7200) till date FIIs have made net incremental purchase of INR84,000 crore while MF has invested INR 153,000 crore. Of this INR153,000 crore INR126,000 crore came in post demonetization in November 2016. In the same period FII’s made incremental purchases of INR42,000 crore. An incremental investment of this level over a 12 month period is among the lowest incremental Net purchases by FII in last 10 years.
In short, higher and higher portion of retail savings entered into the Indian equities at higher and higher P/E.
What about the PUT Option?
With over a INR 100,000 crore coming from MF, the FII or other smart money may gradually move out. The reasons can be anything from rising US interest rate to high P/E of Indian markets and possible delay in earnings recovery. The domestic investment is driven my mandated investment from EPFO, NPS and ‘formalization’ benefit where savings previously held in cash may be coming into equity market. Clearly the domestic liquidity would be able to bankroll some exits, in the event of a large scale pull out by FIIs. Retail investors are the ones who will bear the most losses just like any put option seller.