Trade BankNifty with a short bias

This tuesday, May 3rd 2011, RBI Governor raised repo rate and savings rate by 50 bps. Banknifty had already moved 5% below its peak just in anticipation of this event. To some it might seem something as simple as RBI as having preponed July rate hike and clubbed it with April hike. So Banknifty should go down another 5%, right? Afterall, most industry analysts had anticipated three more 25 bps hikes in repo rate this year and priced it in Banknifty just couple of months back at current price levels. In fact Banknifty is already down another 5% as I write this post so probably we are done going down and its time to look up and see Banknifty making new highs. I happen to believe however that RBI's action is likely to have an impact far in excess of that. Why?

Let me begin by saying that market price is a convergence of expectations of fundamentals. OK, another fundamental analyst you might say! As if we were already not drowning under combined weight of 2500 analysts espousing their views through 25 news channels and 25,000 web pages. Not really. I wrote “expectations of fundamentals” not “fundamentals”.

Wise sages of Dalal street might say so what if banks’ cost of funds has gone up, we are sure they will manage to pass most of these on to their clients. With their NIMs (net interest margins) near intact, they should not suffer more than 10% damage to their net profits. Let’s assume that there is a mega bank named Sarkari Bank of India (let’s call it SBI for sake of brevity) priced at Rs 1500 on 25^th April 2011 and it has an annualized EPS of Rs 100 during quarter ending March 2011. Logically it should see its next year EPS come down to Rs 90 by some fundamental analyst and its price should move down to Rs 1350 in anticipation of that. We are already there on 5^th May 2011. Our efficient stock market has anticipated this fundamental change and priced SBI quickly and efficiently. End of story? Far from it.

This is where something called PEG ratio comes into play – more precisely a resetting of expectations regarding PEG ratio. Wikipedia quotes star fund manager Peter Lynch having popularized PEG ratio (PE to growth ratio) having written that "The P/E ratio of any company that's fairly priced will equal its growth rate", i.e., a fairly valued company will have its PEG equal to 1”. Were banks fairly priced before this down-move began? Yes. When will they be fairly priced again? Well, when Mr Shortpants in the story below is done bringing it down.

In a nutshell, Mr Shortpants thinks that costs of banks have gone up but they are going to have a hard time increase their lending rates to the same extent and even grow their business at the previous year’s rate. This could be one of those fundamental changes which play themselves out over several months. Shortpants believes that banks’s growth rate will come down to 10% from 15% he had forecast in his presentation to his firm’s global head in big apple just last December. So the bank prices need to fall 50% from their peak. Hence the short bias. Now we move to technical analysis. Hard core technical guys can just view the chart and stop reading after next para.

Here is a banknifty chart (very simple daily chart with volume bars) since October 2010. The high during this period was 13,200 and low 10,020, give or take a few points. We have just seen a 400 point fall out of an expanding triangle which brought it to a much larger converging triangle spanning several months and connecting previously mentioned high and low with the next lower high and higher low respectively. A triangle as a technical formation does not reveal what it is going to do till it breaks its boundaries. So far it is holding Banknifty right at lower edge but given the change in “expectation of fundamentals” initiated by RBI, I am hoping for a breakdown of 10,800 level and Banknifty to travel to 8000 in next 3 months. Accordingly I am going to be short on every major pullback from now on till end June. In fact I am already short. Will it really come down to 8000 and that too this year? Do converging triangles spanning several months on daily charts actually work like that? Well they don’t, but Johnny Shortpants sure does. Read below for more boring stuff.

Chandrashekhar

Disclaimer – all the characters in the story below are fictional and any resemblance to any character – living or long dead – is purely coincidental. Also everyone makes mistakes and so do I, so don’t take me too seriously. If you trade based on my views and loose money, my condolences in advance. If you make money however, send a USD 100 cheque to undersigned so I can keep writing similarly inane articles and stories in future as well.

Story - Short and Long of Banknifty

Johnny Shortpants is a 33 year old Harvard MBA and controls USD 10 Billion fund investing in Indian equity markets. Marketswamy Longrajan is a career banker serving his 33^rd year as head of biggest domestic institutional investment firm and has similar funds at his disposal (his Master’s funds actually which happen to be his Master’s subjects’ funds actually, but more on that later). They share a keen need and skill for pleasing their masters and advancing in life thereby propagating their species. Darwin’s law – survival of those who can adapt.

At 11 AM on 3^rd May 2011, Johnny is a smug man. He has seen this repo rate hike coming and has already shorted SBI to the extent of 1000 crore in futures, sold 400 crore in cash, written 200 crore in calls etc to ensure that he is prepared for this hike in rates. He is already invested to the extent of 10,000 crore in Indian banking sector and has booked some profits in the previous quarter. His masters have determined that Indian market is going to underperform in 1^st half this year (was he the one who suggested it himself?) and he is ready to make the most of a bad situation. Just 10 minutes later, he is a worried man. RBI has not only hiked the repo rate by 50 bps, it has also hiked up the savings rate by 50 bps. A rational capitalist to the core, he was hoping RBI would pay lip service to a policy of a gradual freeing of savings rate or something to that effect. Why the hell did they have to do it today? They were contemplating freeing up savings rate for so many years without doing anything about it so why did they have to act on it now? Shortpants scans through policy and starts worrying about things he normally did not worry about in the past. That’s the thing about worrying. It begets more woes just for company. Banks’ doubtful loan provisioning norms have been further tightened as if those were not tight already. Why can’t RBI run Indian banks like good old Fed of NY, US? Let them bundle those doubtful loans as securities and sell it to their own clients as high grade investment. Surely, invisible hand of market will ensure everything turns out fine. To make things worse, RBI Governor has also told banks not to park surplus funds in liquid MFs. How will Banks lend this additional 50,000 crore out without competing more aggressively among themselves? Hell, some of them may have to start working on Friday afternoons to get more business! No one becomes a banker to face this kind of world! Shortpants figures that most of Indian industry was already not investing aggressively into new projects and capacity creation. Home loans volume was already declining due to all time high home prices and a sticky real estate market fuelled by black money. Auto loans were growing really fast but those had already climbed to 15% for most borrowers. How much more can banks increase rates without demand taking a hit? Plus his analyst had figured that RBI would stop increasing repo rate in August and might even hike it once or twice before March. That would have given a nice 5-10% kicker to banks’ earnings given that they need to mark-to-market their long term Govt securities, but that seems a distant possibility now.

Its already 11:30 AM and market is not taking nicely to the RBI policy. Shortpants has decided that his performance for this quarter will be adversely affected if he does not actively short Bank stocks. He can’t just dump his stocks on market – 10,000 crore is not a small amount – so he decides to play it smart. He will start by shorting Banknifty future to the extent of Rs 100 crore only everyday; something he has already been doing last 10 days. Banknifty is going to drag Nifty down too so he is going to let his fund write calls aggressively in Nifty and buy some puts too. That will give a boost to his fund performance this quarter. His plan in place, he calls for a lightening meeting with his staff and issues instructions. A bright girl from IIM-A alerts him to the possibility that his masters may actually ask him the reason for his actions. Shortpants is a trader and is given by nature to act on his hunches but he’s also worldly smart having done his thesis from school of CYA after he finished his MBA from Harvard. Shortpants asks the IIM-A girl to prepare a report along the following lines and email it to HQ from his email ID before London market opens. Maybe she will get a nice raise in the upcoming appraisal.

SBI price = 1500

SBI EPS = 100

SBI growth rate = 15%

PE ratio of SBI = 15

PEG ratio of SBI = 1, hence fairly valued, hence all the previous decisions about buying into SBI have been correct. Going forward however,

SBI expected growth rate = 10%

Expected PE ratio of SBI given fair valuation = 10

SBI EPS for next year = 90

Hence, fair price for SBI by March 2012 = 900

He’s ready with a justification for shorting SBI till it reaches the highly logical and inevitable price point in his terse and sharp report. Plus he is going to be the first one to short and get out, like he always does. He knows Longrajan will buy every alternate day whenever bank prices come crashing down but he also knows Longrajan is not an aggressive buyer. He buys and pauses for further fall in market. That’s the way he’s been operating in this market for decades and it works for him. Longrajan’s masters do not pay him for taking risks but for playing it safe and slow. In fact Longrajan’s masters do not pay him enough to do anything. It’s a wonder that guy shows up at work. Shortpants picks up the phone to call his friend who needs to be given an advance warning otherwise he won’t be welcome to Beachwallah’s annual Roman Orgy theme party coming Friday.

Beachwallah is a worried man – he always is. Market is on its way down and the call from Shortpants has got him worried more. You see, Beachwallah business has something to do with people buying and selling. When Banknifty goes down a lot, people buy lesser and lesser. Plus he has his own 1000 crore invested in SBI. Now he has to take a bad situation and make the most of it. First he instructs his trading head to buy puts on SBI. As many as he can. Next, Beachwallah calls his bright non-descript MBA analyst from next room and asks him to prepare a report on SBI along the following lines.

a) SBI price last week = 1500

b) SBI price today = 1350, hence SBI is cheap

c) SBI is a good blue chip bank

d) Therefore, Buy SBI on every dip

Report has to be simple otherwise BW’s clients won’t understand it. His analyst leaves the room shaking his head in disbelief and cursing the day he decided to join a top notch brokerage firm. His gold medal and MBA degree hangs on his cabin wall mocking him. BW issues instructions to his team on how to go about circulating report and which faded out former star traders should espouse the cause of SBI on TV channels and in what order and then leaves for early lunch at Cricket Club of India. He whistles while he contemplates how and when to give a muddled and unclear warning to his lunch buddies about pending fall in SBI once he is done buying his puts.