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The big crash and the rally

Of the many defining characteristics of Monday's stock market crash and the recovery on Tuesday, a few easily stand out. An intra-day fall in the Sensex of 1111 points in the forenoon of Monday threatened to break all records for single day declines, including the 826 point drop registered the previous Thursday. Volatility that has become a key characteristic of the share markets was spectacularly in evidence on both the days. The Sensex swung as much as 1300 points during the day on Monday to close 456 points lower. In more normal times that would have been seen as a huge drop, but in the context of the extreme intra-day volatility and the recent declining trends, it appeared manageable. On Tuesday, again amidst sharp swings, the Sensex regained substantial ground to close 341 points higher at 10822. Monday also saw the application of circuit breakers, the inbuilt safety mechanisms that automatically stop trading when there are violent swings in the share indices beyond pre-determined limits. There has been no sudden adverse development to mar India's success story in wooing different types of investors, especially the foreign institutional investors. Indeed, amidst all the panic on Monday the fact that this year, until May 18, FIIs have invested as much as Rs.16,630 crore is likely to be forgotten. Equally significant is that domestic mutual funds, having garnered huge sums through their equity schemes, have emerged as significant players. Along with the LIC, they serve as counterweights to FII investments.

There are only partial explanations for the way the stock markets have been behaving recently. The connection between the financial markets here and those outside is becoming stronger by the day. Both the forex and stock markets are reacting increasingly to global developments. Recent declines in share prices in India have followed similar trends in other emerging markets. Serious concerns over the unsustainability of the United States' current account deficit and the possibility of interest rates going up in the developed world have contributed to a reversal of fund flows to emerging markets. Many attribute the sharp fall on Monday to the forced liquidation of over-leveraged trading positions by traders and investors. The flip side of the liquidity-enhancing margin trading system is in evidence. A common sense explanation has been that a correction was long overdue in India but when it did take place on Monday, it was both unexpected and severe. In terms of valuations, it is certain that Indian stocks were overpriced when the Sensex was ruling above 12500 less than 2 weeks ago. The sharp declines have brought down the valuations to levels that would be attractive to investors once again. Retail investors, however, need to be reassured. Violent swings in share prices have dented their confidence in the share market. Even the safer channel of mutual funds would suddenly seem to be fraught with risk.

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