There appears to be some steam left in the rally, though it may dissipate over a longer time-frame than the recent uptrend of about 30 per cent. However, it may not be appropriate to try to call the top for selling and profit-booking.

Yes, this rally is backed up by steady top-line growth, relentless efforts at cost control, higher operating profit margins, a tight leash on interest costs, and good earnings growth for a wide range of companies compared to any other bullish phase in the past.

But the bottomline is that the rally is driven largely by liquidity; needless to add, its continuance hinges on this aspect as well. This was true for every bullish phase over the last 12 years.

The accompanying piece looks at ten stocks — a mix of large- and mid-cap shares — that have held the centre-stage in the recent rally. The infographic presents the prices of select stocks now and on March 8, 2001, when the Sensex slipped below the 4000 mark.

The liquidity story

The undoing of investors in the stock market has been the dubious sources of liquidity, which in 1992 and 1999-2000, came from channelling of funds from the banking system in a highly improper manner. The sources of liquidity fuelling the ongoing rally continue to be shrouded in obscurity. The obvious sources are:

Foreign institutional investors (FIIs), which have poured in $1.7 billion over the past four months.

Private corporate bodies (quite a few of which are controlled by promoter groups) based in India, and overseas corporate bodies — a potent mix in 1999-2000.

Incremental funds — withheld during the sluggish years in the market — channelled back into the market by the big-time market players. This also includes flows from high-net-worth individuals and select corporate entities.

Liquidity infused into the market by traders who intend to capitalise on short-term trading opportunities, apart from day trading. The latter — indulged in by FIIs, domestic funds, big time-market operators and brokers, and a sizeable number of retail investors — has provided the liquidity necessary for delivery-based trades.

The spin-off effects from a surge in trading volumes in stock futures and options. Volumes on the National Stock Exchange's derivatives market have topped the Rs 6,000-crore mark. The outlay required to build positions in options/futures is considerably lower than a spot buy/sell transaction.

For instance, in Tata Motors and Tata Steel, open interest is about 90 per cent — a trebling from the levels that prevailed a couple of months ago. This indicates the heightened levels of interest in these stocks — a trend evident in most stocks where trading in single stock futures is allowed. Coupled with the spurt in volumes in the spot market, the sharp spurt in derivative trading volumes has helped deepen the rally.

FIIs, the key factor

Net inflows from the FIIs are a key factor to watch out for over the next six months. If the FII flows are good, the other factors will continue to provide good support. Strong FII flows between May and August, at $1.7 billion have been the main drivers of this rally.

FII flows into equities and debt are close to their 1996 high of $3.06 billion but, unlike in 1996, only 73 per cent ($2.1 billion) found its way into equities. Yet, 2003 ranks third in terms of net FII inflows into equities (1996 and 2001 taking the top two slots).

The key question is: Will this continue, and for how long? A few factors need to be looked at in this context:

This possible tapering-off of liquidity needs to be tracked closely. Given the trends across various markets, it is unlikely that the FIIs will be net sellers in a big way in 2003.

Even if their net inflows turn modest, in keeping with historical trends, the downside risks may be limited. This is due to the better quality of fundamentals, and a continuing positive outlook for earnings growth, at least over the next six months. The downside risk appears to be the bigger threat from quite a few mid-cap and most small-cap stocks, cutting across sectors. Risks to frontline, large-cap stocks may emerge if there is large-scale selling by FIIs.

Unlike in the past two-and-a-half years, FIIs as an investor class now have a portfolio that affords profit-booking opportunities. Funds are, however, unlikely to be pulled out in a short time-frame as FIIs may seek to avoid sharp price declines, linked to their selling decisions.

Options for investors

Having got accustomed to the market languishing in the 2900 - 3500 Sensex range, the index crossing 4000 does raise doubts whether the rally is overdone, and if investors should start pulling out. The answer to both these questions is yes and no.

The way in which the rally has been compressed in a short time-span of three-and-a-half months, and progressed in a relentless fashion with few, if any, corrective phases, is cause for concern. But the market is not as overvalued as it was during the bullish phases of 1992, 1999-2000 or, for that matter, 1994-95.

In such a market, here are a few pointers as to what investors can do (see also "What to watch for and do", Business Line, July 6, 2003):

Investors who entered frontline large-cap and mid-cap stocks in the March 2001-March 2003 period could be sitting on gains of 60-100 per cent on a conservative basis. For such investors, it makes sense to partially book profits — by selling 30-60 per cent of their holdings, depending on risk preferences.

The remaining holdings can be pared at any significant increase from present levels. The magnitude of increase is bound to be different for different stocks. So investors should cut exposures if their target returns have been realised. It may be better to contemplate re-entry at lower levels, when the liquidity in the market wanes.

The rally has seen a range of second- and third-rung stocks as well as a host of also-rans pick up steam. These stocks — especially in the steel, textiles, cement and engineering sectors — have increased by several times. Shah Alloys, Panyam Cements, Rathi Alloys and Nahar Spinning are some instances. Exposures in this category of stocks can be cut completely, as this is an opportune time to exit.

The market is at a stage where fresh investments have to be made extremely carefully. Even if the stocks in question are good, it may be better to wait for the big-ticket FII liquidity chasing stocks now to wind down to lower levels. Else, one would unnecessarily pay a higher price.

Close to 1,000 stocks have re-emerged from trading hibernation — the number of stocks traded on the BSE has risen from about 1,100 to 2,200. In such stocks, exit options must be exercised completely as they would be the first to disappear, either when the ongoing rally peters out, or if the market starts to consolidate higher.

If you are trading in options and futures, examine the level of open interest and number of contracts. If there have been very sharp increases in a short time — as is the case with many contracts now, it may pay to be cautious.

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