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Why Retail Investors Should Exercise Caution in a Bull Market

Why Retail Investors Should Exercise Caution in a Bull Market

Indian retail investors have never been so bullish on stocks. They come to the market in hordes, and try every trick and avenue—from penny stocks to algos—to make a quick buck. But even with the euphoria, it is a good time to exercise caution

Illustration by Nilanjan Das Illustration by Nilanjan Das

"If you don’t find a way to make money while you sleep, you will work until you die.”

What Warren Buffett meant was that one should have a steady income stream in place, irrespective of whether one is working, vacationing or sick. Or perhaps, even when one is literally sleeping! But as is the case with most adages, people have interpreted the legendary investor’s words in a way that suits their actions or convenience.

Record numbers of retail, or individual, investors in India are entering the stock markets and capitalising on the year-and-a-half-long bull run—some even while sleeping. What else would explain the investor behaviour in the market currently, especially in the cash (or spot) market?

According to data from the National Stock Exchange (NSE)—the country’s largest by market share in the cash and derivatives market—net investment by the retail segment was Rs 51,200 crore in 2020 in the cash market. That has already risen to Rs 86,000 crore this year till September.

This is much higher than the institutional participation in the same period. As per NSE, foreign portfolio investors (FPIs)—traditionally considered the prime drivers of a bull run in the Indian stock market—have been net sellers so far, at Rs 30,600 crore, in the cash market. And while domestic institutional investors (DIIs) are net buyers, the amount is a mere Rs 9,700 crore, as per the exchange.

This contrast is also reflective of the record number of retail investors that have entered the market since the pandemic. Retail traders accounted for 45 per cent of all investors on the NSE in FY21, a significant jump from 33 per cent in FY16. More than a million new accounts were created in each month this calendar year, with a new high being set each month.

That’s no surprise, considering the Indian stock market is among the best performing globally this year. The benchmark Sensex and Nifty have gained nearly 27 per cent and 30 per cent, respectively, this year through November 10. Generally, this sort of retail interest is the hallmark of a healthy equity investment culture as people opt for well-regulated and transparent public markets over physical, but opaque, asset classes such as real estate and gold.

However, the market’s bull run has a few worrying signals. Stocks across sectors are at record highs, as are valuations, but without a corresponding shift in fundamentals. A cursory glance through India Inc.’s financial reports clearly shows headwinds looming, such as rising crude prices and inflation, which are bound to impact profit margins.

Concerns of an impending correction have increased, almost in lockstep with the stock market’s gains. Many market experts believe investors—especially the average retail ones—should reduce their exposure to the market as stretched valuations, the slowing pace of foreign inflows and margin pressures have increased the probability of a steep correction.

In fact, CLSA believes Indian equities are “on borrowed time” and has listed 10 reasons to book profits. “Our concerns range from elevated energy and broader input price pressures applying downward pressure on margins … (to) rich valuations, a high probability of earnings disappointment, and a potential lack of marginal buyers.” These factors, the global broking and research firm said in a report, “add to our motivation to book profits on India”.

Retail investors, though, have only been increasing their bets in the stock market and are even trying innovative ways to make money while the party lasts. Even if that means increasing the risk quotient.

Rise of the Software

Ankush Sawant is no novice trader. The 37-year-old Mumbai-based techie started with intra-day trading in 2008 and moved to derivatives in 2012. By 2015, after a few misplaced bets, he realised that a long-term, fundamentals-based view was the only prudent approach to make money in the stock market.

But Sawant’s resistance capitulated this year amid the retail euphoria. He started dabbling in commodities, about which he has very little insight. More importantly, he adopted algorithm-based trading.

“A few months back, I started using algos for trading,” says Sawant. “These algos fire trades based on predetermined parameters and I have no role in the stock selection or trade execution. With the help of algos, I have started trading in silver as well. The vendor has assured me a minimum rate of return in lieu of a fixed annual fee.”

Sawant is not alone. He’s part of a growing breed of new, tech-savvy investors ready to use software tools to try their luck in the capital market.

Many unregulated algo platforms have mushroomed in the country, luring clients with the promise of a minimum rate of return or even by pitching a profit-sharing arrangement. These platforms connect directly to an investor’s trading account and make trades without any manual intervention.

“This is a concern, with people selling off-the-shelf kind of algos. Investors go to these platforms because they promise extraordinary returns. Some even work on profit-sharing arrangements,” says Nithin Kamath, Founder and CEO of Zerodha, India’s largest broking firm in terms of active clients.

“These platforms are selling greed by claiming that investors can make a certain percentage of return every month. If they are regulated, they will not be allowed to sell returns, and a lot of problems will get resolved automatically. As of today, it is not a very large market, but it can potentially become large if left unchecked. There are risks around these strategies, like execution risks, front running, etc,” says Kamath.

There is also a bigger risk, one that any software perhaps cannot compute.

Warning Signs

1992. 2002. 2008.

History is replete with instances of the vast universe of midcap, smallcap and the so-called penny stocks galloping ahead of their fundamentals, only for a steep correction to follow.

And history seems to be repeating itself now. Both the BSE Midcap and BSE Smallcap indices have outperformed the benchmarks this calendar year. Except in the past month or so, which is the worrying sign.

In the month through November 10, the Smallcap index shed nearly 1 per cent, while both Sensex and Nifty logged marginal gains. More importantly, the broader indices lost ground in many sessions recently, while the benchmarks traded strongly or closed higher. These are similar to the trends that were a precursor to corrections in earlier periods.

While it is anybody’s guess if and when the market will eventually correct, the warning lights are flashing. And retail investors, by virtue of their burgeoning exposure, need to be the most cautious. Especially because many of them entered the market last year when stocks were battered by the pandemic, and have since ridden the crest of the rally. In other words, they have never experienced losses or a downturn.

For them, a word of caution from the highest echelon—Ajay Tyagi, Chairman of India’s capital markets regulator, the Securities and Exchange Board of India (SEBI). “The first thing the investors need to understand is that any financial investment comes with a set of risks,” Tyagi said at The India International Trade Fair in mid-November. “If they are not able to assess the suitability of a particular financial product, it might be wiser to remain away from it rather than going the wrong way. Investors should be careful against getting carried away by the lure of unrealistic returns in the securities market. Many times, undesirable elements take advantage of gullible investors by making promises that are too good to be true. Investors are advised to be cautious of such offerings.”

While retail investors might be turning a blind eye to the signs, one set of traders is not.

Drivers Take the Back Seat

More often than not, FPIs have been at the forefront of any bull run in the Indian stock market. In other words, they also traditionally lead the race to the exits.

And while the emergence of DIIs—such as mutual funds, pension funds and insurance companies, among others—in the past couple of years has acted as a strong counterbalance, the signals by FPIs cannot be ignored this time around.

Though FPIs have been net buyers at $6.9 billion this year through November 16, that is significantly lower than the previous year’s $23 billion and the $14.4 billion in 2019. Further, FPIs have pressed the sell button recently, offloading shares worth nearly $2.5 billion between October and mid-November.

Foreign investors come to emerging markets, including India, lured by the promise of returns such economies offer when interest rates are low in developed markets. But, with reports that global central banks, including the US Federal Reserve, are looking to raise rates, markets such as India are likely to see a continued slowdown in the pace of investments by FPIs.

And history shows that even DIIs will be hard-pressed to balance the scales when FIIs stampede for the exits.

The Sensex tumbled more than 52 per cent in 2008 when FPIs were net sellers at nearly $12 billion. In 2018, the index rose less than 6 per cent as foreign investors offloaded Indian shares worth $4.4 billion. To highlight the opposite effect, the Sensex rose 28 per cent in 2017 on the back of nearly $8 billion worth of foreign inflows.

But more than the demons of the past, the unicorns of the future are luring investors.

Racing Ahead of Fundamentals

Zomato listed on the stock market a few months ago, while Nykaa made a blockbuster debut in November. Paytm’s hotly-anticipated debut turned out to be a damp squib on November 18, with shares falling 27 per cent below the IPO price.

These start-ups offer tremendous growth potential, but almost none has any near-term plans for profitability. Yet, many investors don’t consider such weak fundamentals (relative to larger, listed peers) a hindrance and are snapping up these stocks. That adds a new layer of risk, says Kamath. “We are in a bull market, but it could potentially turn around any time. Any kind of overexposure to equities is risky, especially in high-growth but not fundamentally strong companies. Currently, there seems to be overexposure to such companies because of the IPOs,” says Kamath.

Dhiraj Relli, MD and CEO, HDFC Securities, has a similar view. “Markets are up for correction. The current euphoria is up for a reality check. We have been cautioning retail investors to be very selective in markets while focussing only on well-run companies.”

Not everyone is convinced, though. Like Shankar Sharma, a market expert well known for his frank views. “We are still in a phase wherein taking too little risk or no risk is foolish. We have come out of a big bear market (last year) and the monetary policies of central banks globally have ensured that the risk is off the table for some time,” says Sharma, Vice Chairman and Joint MD of investment management firm First Global. “There is an increased propensity of risk-taking among investors and, with so many new investors coming to the markets, it is wrong to assume that everyone is foolish. One shouldn’t be totally sceptical. The environment is conducive for risk-taking.”

While only time will tell if or when a correction will occur, it is also foolhardy to ignore the warning signs. There are clear indications that the stock market is in uncharted territory and the underlying drivers are brittle. Even the international environment seems to be advocating caution—the possibility of a sooner-than-expected US rate hike, a weakening Chinese economy, high energy prices and input costs, and the phased withdrawal of stimulus by central banks. Many first-time investors dove into India’s capital market last year and were lifted by the rising tide. But the water is getting choppy and they would do well to not misappropriate Buffett’s words this time. “It’s only when the tide goes out that you learn who has been swimming naked.”


Published on: Nov 26, 2021, 6:36 PM IST
Posted by: Vivek Dubey, Nov 26, 2021, 12:32 PM IST