Signs of cooling down

“Hot money" is one of those phrases that can mean many things. Sometimes it's earnings from illegal activity. It could be counterfeit. Most of the time however, it means cash deployed by traders; heavily leveraged and liable to switch direction at moment's notice. Nobody quite knows how much of the cash in Indian markets is "hot". You cannot get a complete picture. All one can say with confidence is that there is lots of it.

One indicator could be the delivery ratio - that is, the volume of delivery as a percent of the total trading volume. This varies. Delivery ratios range from 5 per cent to over 50 per cent in different stocks.

Obviously all non-delivery trading is done with "hot money". But quite a lot of deliveries are "hot" as well. Some deliveries are on borrowed cash. At other times, delivery is offered by somebody who has borrowed stock. There is no means of checking.

Then again, there are the Foreign Institutional Investors (FIIs). All FIIs take delivery, including the hedge funds and participatory note (PN) players. But the hedge-funds and PNites will exit at a moment's notice. Their cash is borrowed overseas. Nobody has a break up of hot versus "cold" FII funding. The RBI and the Ministry of Finance steadfastly avoids calculating and releasing such details for fear of spooking PN players - not that it would be easy to make such calculations in any event.

Hot money is usually deployed in tandem with the prevailing trend,whatever that may be. It tends to emphasise and underscore directional movements. If the market or given scrip is up, it attracts momentum traders. When they book profits or losses and head for the next fashionable trade that too, lends emphasis to bearishness .

The hot money is obviously exiting Indian stocks at the moment. In fact, it's exiting every global stock market. That's because the hot money depends on leverage and leverage depends on willing lenders. Given a crisis of confidence in US mortgages, lenders are extremely conservative at the moment. They need to know the butchers' bill in US subprimes before they regain a measure of confidence. That means highly-leveraged hot money must cut its exposures.

We saw a similar scenario during the Asian Flu of 1997-98. Last year as well, the crash in the global metals market caused a stampede out of stocks. The good thing about hot money is that it moves fast. We won't know the dimensions of the FII selling until it's actually over but the bulk of exits may be complete by end-August.

We can have an inkling of FII mindsets by examining gross derivative exposures. FII derivative exposures have shot up. They have a vast number of open short positions in stock futures and a very large number of open short positions in index futures as well. In index options, they have bought a massive number of calls. The long calls are presumably hedges against the market jumping. The shorts are Texas Hedges whose positions shot on top of net sales in the spot market, under the assumption that prices will drop because of spot-selling. If that mix of FII exposure changes, either before the August settlement is through, or early into September, there will be reason to believe that all the hot FII money is out.

The stocks that will be hit hardest during this exit-phase will be the F&O group and top-ranked mid caps. These are the counters where FII positions are close to limits. The mid caps are high-beta counters where hedgers have pumped up the prices over the past two years and also neared the FII-limit.

Post-exits, only the "cold" money of non-leveraged, long-term investors will be left in the stock market. The rupee will probably soften quite a lot as FII flows reverse. There is also likely to be a large fall in liquidity across the entire spot and F&O markets. That will retard fast price recovery in most counters. However, there will be little downside left and that is a perfect situation for long-term players.

The stocks that get hit hardest by hot money exits are also some of the best businesses available. Valuations would be very attractive if the Nifty dropped to say, 3500. That would be roughly 25-30 per cent correction. It happened in 2006, it could likely happen again. If you start buying now for the long-term, stagger purchases to ensure averaging down. If you use "hot money" yourself, wait till the FII derivative exposure mix changes and the rupee drops before you go long.