Some early lessons from the Adani stock crash

The sudden and steep crash in Adani group stocks took away some of the glow of the Union Budget news headlines. The total loss of wealth in market capitalisation was a staggering 100 plus billion dollars (i.e., 9 lakh crore rupees) between January 24 and February 3.  This is one fifth the size of the Union Budget presented by the finance minister. The fall is across nine companies ranging from green energy, ports, power, and cement, all connected with India’s infrastructure. The fall was almost 50 percent, which means half the value is still retained. Infrastructure is a very crucial and structural determinant of India’s growth story. And for the next two decades it will be a powerful engine, so long as enough money is poured into building infra, be it from public or private sources.  Any company, industry or business exposed to India’s infrastructure building, cannot but be profitable. Yet the dramatic fall in Adani stocks has many lessons for investors, policy makers, and most importantly for regulators.

Yes, the price was falling. But if you say there was a wave of selling, then surely there was also a wave of buying. Who were these buyers?

First to note is that when stocks fall, the headlines say, “there is a wave of selloff”. As if everyone is just selling the stock. But remember that in an exchange not even a single share can be sold unless there is a buyer. For every Adani stock that was sold during this fateful week, there was a buyer on the other side. Yes, the price was falling. But if you say there was a wave of selling, then surely there was also a wave of buying. Who were these buyers? Were they short sellers, who had sold in advance the shares that they did not own (this is the modus operandi of short sellers), and were buying and mopping up shares in a falling market to deliver it to their counterparties?  This is for the regulators to investigate, although per se there is nothing illegal in bargain buying a stock which is falling like stone.

The second thing to note is prices fall or rise steeply even with a few transactions in an illiquid asset. This week newspapers reported the distress sale of 28 flats in central Mumbai for 1238 crores, all bought by members of a family. The implied price is between 65000 to 75000 rupees per square foot. Has it fallen sharply from 90000 rupees that prevailed not too long ago? In a market with thousands of luxury flats, the illiquidity impact, means that the sale of a mere dozen flats, can move the price steeply affecting the value of all those thousand flats which have no transactions to show. The same is true of the stock market. If the market is “liquid” with plenty of buyer and seller interest at all times, the transaction volume cannot move the price so suddenly and steeply.

That is why for stocks listed on stock exchanges the regulator Securities and Exchanges Board of India (SEBI) insists on a “public float” of at least 25 percent to be held widely, diffused, across many, preferably small investors. So that for any seller there is likely to be buyer who has an opposing view about that stock. Thus, price sentiments have pressure from both sides. In the Adani stock carnage, surely if one party was selling there should have been an opposing sentiment, much more bullish on the India infrastructure story. The problem was with inadequate liquidity. This is where the stock became vulnerable for a steep fall.

Short selling in Indian capital markets, be they stocks or bonds is very hard

The lesson for SEBI and the exchanges is to keep a strict watch on adequate liquidity and strict adherence of public float in letter and spirit.  In the absence of liquidity, the price can move sharply in both directions. And hence the price to earnings ratio (P/E) can zoom like anything. Last year at the time of its initial public offering, the new age company Nykaa’s market value (and hence P/E ratio) zoomed into the stratosphere. This despite the profits being meagre.  Such P/E ratios, especially those that rise suddenly, are difficult to justify, let alone understand.

The third thing to note is that short selling in Indian capital markets, be they stocks or bonds is very hard. In stocks, the short seller must borrow shares in advance before short selling. No “naked short selling” is allowed. The price for borrowing shares can be quite steep depending on the volatility of the stock. Of course, Indian shares or bonds listed abroad can be short sold in those markets, but Indian regulators can’t do much about that.  

The exchanges and SEBI must be very careful about how the index stocks are selected

Short sellers take great risks and bet large amounts and make a useful contribution to improving the “information” content in the market.  There are many instances when short sellers have been “squeezed” because they sold much more than was available and had to make up by buying at huge premia, and ultimately got wiped out.  The responsibility of ensuring everyone obeys the law is up to the watchdog, i.e. SEBI. Some countries just have outright bans on short selling. But that is like banning all negative feedback about any company.

The fourth thing is about the circularity of index funds and the Sensex. The latter is just an average of 30 stocks. If one or two of those large stocks is zooming it can take the Sensex higher, even if all the other stocks are declining. This forces index funds which passively mimic the Sensex into pouring more funds of retail investors into those very stocks which zoom further. This circularity can be dangerous and cause instability, eventually possibly sharp drops. So, the exchanges and SEBI must be very careful about how the index stocks are selected. In 2022 the NASDAQ which has 100 stocks was down 34 percent, S & P with 500 stocks in the index was down 20 percent, but Indian indices were up 5 percent. Some of this is due to India’s resilient economy no doubt.

Lastly, stock market sentiment follows herd mentality. Hence a big fall spooks many potentially small investors (and vice versa), and reactions can be wild, affecting the whole market. This is an externality, a spillover effect. No doubt that the Adani group will do its utmost to bounce back, but regulators and policy makers must ensure that investors’ trust in the markets is not dented. India’s stock markets are world leaders in terms of technology and surveillance systems. The regulators and exchanges must match that in terms of excellent governance and strengthening the foundation of trust.

(Dr. Ajit Ranade is a noted economist)