Where are the markets headed?

Stocks below a certain size in terms of market capitalisation don't attract much institutional interest

Differentiating returns by sectors can often yield useful insights. Industry segments tend to move in the same direction at the same time. Of course, there will be market leaders in every segment but every company in any given sphere of business may benefit (or suffer) from some of the same variables. For example, when the cost of metals rises (or falls), metal producers benefit (or suffer).

At this moment, no major sector has positive returns for the past month. However, the Information Technology (IT) sector is a relative outperformer since the Nifty IT index has lost only 2.2 per cent in the past month, while the Nifty has lost 6.2 per cent. Another outperformer is the energy sector where the index loss is 3.8 per cent in the same period.

In the case of IT, the weaker rupee is probably a factor along with reasonable results declared by majors like Infosys, HCL Technologies, Wipro, etc, for the quarter ended December 2015.

In the case of the energy sector, crashing crude prices (and falls in coal and gas prices) have been beneficial for refiners and marketers. The improved performance of this sub-segment has helped to somewhat offset losses for exploration and production.

Can differentiation of returns by size, rather than sector, help yield useful insights? We know that, by and large, smaller stocks can offer larger returns. In simple mathematical terms, it is much easier for a small, cheap share to multiply in price.

It is also easier for a small company to register large percentage gains in revenue, earnings, etc. So, an investor who buys into a small company and holds until it becomes a medium-sized or large company gets fantastic returns. Of course, small businesses also collapse easier than large ones, so the risk is more.

Moves in small stocks indicate retail attitude. Stocks below a certain size in terms of market capitalisation, don't attract much institutional interest. Big movements in small stocks are, therefore, usually driven by retail interest.

If a large number of small stocks move up, retail attitude is positive. A simple way to judge this is through observation of advances versus declines (A-D). If advances exceed declines, retail attitude is most likely positive. Conversely, if declines outnumber advances, retail may be bearish. A-D numbers can be calculated across different timeframes and sliced / diced in many ways.

Other secondary observations can be gleaned from small stocks. Usually retail interest develops late in a bull run and often continues when institutional investors are selling off. This can create divergences, which are hard to read.

For example, suppose the A-D is positive (more advances) for the broad market, but the major market indices are falling? A superficial look will suggest that a bull run is around the corner, given the A-D has positive divergence. But, the divergence could also be interpreted to mean that institutions are selling, while retail is buying. How do you judge if institutional attitude will improve, or retail attitude will get worse?

As of now, institutions appear divided in attitude. Domestic institutions have remained buyers through January, while Foreign Institutional Investors (FIIs) have been sellers. Retail sentiment was apparently strong at the beginning of January, but it is weakening now, going by a deteriorating A-D ratio.

This leaves the market poised to go in either direction. If institutional attitude (meaning FII attitude) improves, the market could rally sharply. But, if FII attitude gets worse, the worsening retail attitude means that retail investors will not help prop up the market.

Illustration: Uttam Ghosh/Rediff.com

Devangshu Datta is a technical and equity analyst