You can take your pick of all the reasons offered for the market crash of mid-May. Some people will insist that it was a metal bubble, others will say it was the frisky Fed.

Indo-centric traders will blame the confusing new CBDT draft guidelines, or the fallout from the DP scam. Plus, there are assorted, exotic conspiracy theories floating around the bourses. Undoubtedly many future PhD theses will centre on the event. Who knows, maybe somebody will even win a Nobel explaining why it really happened.

There is a simpler way to understand those two short weeks when a two-year bull run in global commodities and stocks turned into a bloodbath. The bottomline is that stocks and commodity prices are driven by money. If there's money flowing into these financial assets, prices rise. In May, when the money flowed out, prices fell.

Why did the cash exit? It became too expensive. A substantial proportion of global financial assets are held by traders gambling at high leverages with borrowed cash. Leverage is a two-edged sword. A small gain is magnified into a large one but a small loss also turns into a big one. So, if you're playing the leverage game, you cannot afford to sit out even a small twitch in the wrong direction.

Here's how it works. A broker says that he will require a 20 per cent "margin" to allow day-trading. That means, he will allow a day-trader to buy (or sell) Rs 100,000 worth of assets if she deposits Rs 20,000 as "margin".

Assume that on a buy, the stock rises 10 per cent. The Rs 10,000 profit translates into a 50 per cent gain due to leverage. Gains or losses are settled at the end of the day (it's called "marking to market") with the appropriate adjustments in margin.

A day-trader usually operates at about 5:1 leverage in the stock market. Other markets offer higher leverages - 10:1 is normal in futures and 20:1 is available in some commodities. So, it's very tempting to borrow seed capital and play on margin. This is exactly what hedge funds and day-traders do all around the world in the hope of magnifying the (anticipated) gains.

When the trade doesn't end sunny-side up, the losses are equally magnified. And, either way, you have to pay the interest if you've borrowed the margin. What's more, when the broker calls to say that the margin on deposit has been wiped out by losses (that's why it is known as a "margin call"), the trader has two unpleasant few choices. Either, put up more money to maintain the position or liquidate the trade at a loss.

Margin mangle. In early May, every global stock and commodity market was ruling high. Most traders and speculators were holding heavily leveraged long positions in the expectation that prices would travel even higher. On May 12, prices softened a little and traders everywhere saw margins eroding. Some sold on May 15 and that drove prices down again. Then, more traders got stuck in the margin mangle. Most decided to cut losses rather than put more borrowed cash down and hope prices would reverse. That enforced liquidation led to ever-lower prices.

This happened all over the world and India could hardly remain unaffected. Desi operators and day-traders are just as aggressively leveraged as anywhere else in the world. And anything up to 50 per cent of FII inflows are estimated to be hedge fund flows coming in through the participatory note (PN) route.

The FIIs sold Rs 2,477 crore (Rs 24.77 billion) during 12-19 May as the hedge funds liquidated. As margin calls cascaded, there wasn't enough liquidity to support prices. Indian mutual funds did buy Rs 2,932 crore (Rs 29.32 billion) in that crucial week but although that offset FII sales, Indian traders and operators were also selling.

The graph displays the sum of monthly FII and Indian fund positions against the monthly movements of the Sensex since April 2005. As you can see, when the big boys are substantially net positive, the market rises. When they're lukewarm, or negative, the market falls. Traders and operators take their cue from institutional attitude.

In March 2006, just after the Budget, they went on a huge buying spree to the tune of Rs 11,117 crore and drove the market up by 909 points. In April, and May, when they were more lukewarm (though still net positive), prices could not be sustained at the 12,000-plus levels.

One primary effect of margin calls is that losses are spread across every sector-even where there should be no apparent infection. When the price of aluminium drops, it's understandable that Hindalco's [Get Quote] price would take a hit. But margin calls ensured that the price of Satyam [Get Quote] and Infosys [Get Quote] would drop along with the price of aluminium, although it seems absurd at first glance, given that IT companies have nothing to do with primary metal production.

Volatility. Another important effect of margin calls and indeed, of leverage, is abnormally high volatility. The chart maps the effect on the market. The average daily volatility of the Sensex in the past five years is around 1.79 per cent as displayed by the horizontal line. That is, the daily high-low range of the Sensex is about 1.79 per cent of the closing value.

Since April, volatility has risen noticeably as more and more leveraged speculators got into action. In mid-May, daily volatility jumped to over 8 per cent as losing traders were forced into across-the-board liquidation. By the end of the derivatives settlement (25 May, a couple of days after the time of writing), most of the margin players will be killed or missing in action. The volatility will probably ease after that and trading volumes will drop.

Until the volatility does ease off, this is not an ideal environment for an investor. A simple example will make it clear why a long-term investor should avoid a volatile market. Assume you've placed an order to buy a share, which closed the day before at Rs 100. If the market swings a lot, either you don't get your trade or you make an "at market order" and, let's say you get it at Rs 105.

Sometime later, you discover that the stock has shot up to Rs 200 and you decide to book a profit. Instead of selling at Rs 200, you end up selling at Rs 195. Net-net, due to volatility, your actual return is 85 per cent instead of the 100 per cent you assumed. If the market is moving around at a relatively sedate 1-2 per cent, execution errors won't cost too much. At 8-per cent plus, the errors are significant even in the long-term.

Once the volatility eases, it will be easier to select stocks on fundamentals and hope to buy them at relatively predictable prices. However, the disappearance of speculators also means the loss of a certain amount of liquidity. This could make it difficult to fill orders in small caps and even perhaps in some of the smaller mid-caps. You may have to invest slowly over a long period or stick to the universe of larger mid-caps and index stocks, where liquidity will always be sufficient.

Which sectors should you target? My primary picks would be in IT and metals. Yes, metals have been the worst-hit sector in the current crash. However, there seems to be a consensus across the universe of commodity-trackers that the long-term demand for metals remains strong.

More than just that, Indian metal producers are impressive businesses, which display sensible cost-control and aggressive marketing. In most sectors, a 10-15 per cent price decline still leaves stocks priced at expensive PEs. Hindalco, Sterlite and Hindustan Zinc [Get Quote] have all seen 20 per cent plus selloffs, which brings the current discounts into the realm of the rational. Each of these is capable of surviving a downturn in the commodity cycle if that is around the corner. If the cycle is strong, they'll offer excellent long-term returns. Admittedly it looks a risky bet.

IT is a less risky proposition. My argument here is that the big three (TCS [Get Quote], Wipro [Get Quote], Infosys) and, to a lesser extent, Satyam have all delivered 2005-06 returns which met analysts' expectations. All have offered decent projections for the current fiscal. Nevertheless, the sector has underperformed the index (the CNXIT has returned 0.07 per cent in 2006, while the Sensex has returned 14.85 per cent).

Sensex Rise and Fall: Complete Coverage

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