Is the retail rush good for the market?

The odds were stacked high against stock markets in the last week of February. Institutional investors were worried about tightening liquidity as the US Federal Reserve embarked on the path of aggressive monetary tightening. Russian invasion of Ukraine and the consequent spurt in crude oil and other commodity prices added to investor worries, causing a sharp sell-off in equity markets globally.

But the correction was quite shallow and one month later, the Nifty50 has already recovered 10 per cent from the March lows. What’s more, it seems to be sailing breezily towards its previous life-time highs recorded in the last quarter of 2021.

It is hard to give a rational explanation for stock market moves at the best of times. The recovery in stock prices over the past month is especially surprising since foreign portfolio investors have pulled out copious amount of money from Indian equity market this calendar, with net outflows amounting to ₹1,12,402 crore. Domestic institutional investors have also been wary in the ongoing phase, aware of the risks posed to corporate earnings by rising input costs, slowing growth and increasing uncertainty.

But new retail investors who continue to enter stock markets are carrying on their trading activities, oblivious to the risks posed by current conditions.

Lack of fear in market

The optimism of retail investors is reflected in the market sentiment gauges, which are signaling absence of fear in the market. The most widely followed market sentiment gauge is the CBOE volatility index, also called the VIX. This ‘fear gauge’ captures the extent of fear and greed in the market, based on the 30-day expected volatility based on the prices of put and call options of S&P 500 index.

Since option premiums increase in times of market panic, the VIX also moves higher. So, higher the VIX, more the fear in the market. A desi version of the CBOE VIX is the India VIX based on Nifty50 put and call options.

The CBOE VIX hit a 52-week high of 31.98 on March 4, 2022, when the Russian invasion was making crude oil prices spiral higher. But the reading has declined since then to 19, indicating that traders are quite sanguine about the prospects for stocks. The CBOE VIX has mostly traded between 20 and 40 since 2007, crossing the upper boundary only twice. It hit 79.13 in October 2008, when the Lehman debacle took place following the global financial crisis. The second instance was on March 20, 2020, when it hit 66.04. This was when Covid-19 was declared a pandemic.

The India VIX is following the CBOE VIX closely, hitting the high of 26.74 on February 24, 2022, which is well within its long-term range. The highest reading of India VIX was on March 27, 2020, when it recorded the high of 70.39.

The fear gauges in both India as well as the US show that investors believe that the Russia-Ukraine conflict will not cause a sustained decline in stock market. The CNN fear and greed index too has moved to neutral reading of 53 from extreme fear a month ago.

Stock market turnover soars

The other indication that trading sentiment in India is upbeat is shown by sustained increase in derivative turnover on exchanges. The number of derivative contracts traded on the NSE crossed 22.07 crore in February 2022, the highest ever, and the tally for March is going to be quite close to this number.

Value of derivatives traded on the NSE had hit record highs n 2020-21 as the pandemic attracted a large number of new investors to the market. Value of equity futures and options trades on the NSE was 86 per cent higher year-on-year in FY21. But the growth was even better in FY22, with value of F&O trades 160 per cent higher.

According to World Federation of Exchanges, the increase in trading activity is not restricted to India alone. As per its latest report, stock index derivatives contracts surged globally in the third quarter of 2021 at 6.59 billion. This was 28.9 per cent higher than in the second quarter of 2021 and 66.1 per cent higher than in the third quarter of 2020.

Retail investors drive the frenzy

The surge in trading turnover is linked to retail investors flooding stock markets since the beginning of the pandemic. A combination of factors including free time available to people while working from home, increase in digital adoption during the pandemic and stellar rally in stock prices from the pandemic lows seems to have made new investors rush to trade in stocks. The fall in interest rates, could be another reason contributing to this rush.

The surprising part is that there was no abatement in retail investor interest in stock market in 2021. According to NSE, there was significant increase in new investor registrations in FY21; 1.05 crore new investors were added. The addition in the first 11 months of FY22 has been much higher, at 1.7 crore new investors.

Along with the increase in number of retail investors, their share in cash segment turnover has also jumped sharply to 45 per cent by FY21. Retail investors have been on a buying spree for six consecutive months up to February 2022 in the cash segment, according to NSE.

Their share in stock options turnover has increased to 33 per cent in FY22 from 29 per cent in FY20. Similarly, their share in index options turnover has surged from 27 per cent in FY19 to 33.6 per cent in FY22.

Regulatory dilemma

This surge in retail investor participation is both a boon and a bane. Lack of penetration of equity investing in the country has been a problem that has dogged regulators for long. The pandemic seems to have been an inflexion point as far as attracting retail investors to stock markets goes, with the number of retail investors more than doubling over the last two years.

But the moot question is: are these retail players investing or trading? The exponential increase in equity derivative turnover over the last two years shows that most of the new entrants are indulging in trading rather than investing. While the market depth does improve due to this increased participation, it does not really help in the capital-raising endeavours of the companies. Also, with derivative trading concentrated in just Nifty50 and Bank Nifty contracts, broad-basing the activities in the derivative segment is essential.

The influx of new investors needs to be encouraged as it is good for the long-term health of market. But the new investors should be gently nudged towards long-term investing for their own good as well as in the interest of the economy.