Puncture Perfect?

The benchmark BSE Sensex fell by a massive 1,500 points fromover 20,000 to under 19,000 in the short period between January 6 and 17 thisyear. Is the stock market rally finally coming to an end?

Nirmal Jain, chairman of the IIFL Group, isn't optimisticabout the outlook for the rest of the year. "Indian equities are going toface tough times for the next six to nine months." Says Sandesh Kirkire,chief executive officer, Kotak Mahindra Asset Management Company Ltd: "Afuture push to the markets would be driven either by strong liquidity flows orlarge earning upgrades. Both seem unlikely at this juncture. Markets,therefore, should move sideways over the next six to nine months giving a highsingle-digit or a low double-digit return." Jain agrees that the stockmarkets will move in a 'range bound' fashion, but in addition to liquidity andcorporate earnings, he is worried about growth.

"There may be a drop in GDP growth by a percentagepoint because of various factors, including inflation," he says.

Sunil Kewalramani, CEO, Global Money Investor, believes thatthe BLIP we have seen over the last 10 days is because of the FII factor. Hesays, "FIIs made net purchases of stocks worth Rs 1,823.50 crore betweenJanuary 3 and 5. In a sharp reversal, they made net sales of stocks worth Rs4,419.20 crore between January 6 and 17. That pretty much explains the recentdecline in the market."

Money from FIIs, of course, plays a major role indetermining the fate of the stock markets. Says Mahesh Vyas, managing directorand CEO, Centre for Monitoring the Indian Economy, "While the influence ofFII money in the Indian stock market is small in aggregate terms, its impact isbig in marginal terms, in terms of the money that actually goes in andout." Not surprisingly, FII money is described as hot money and iscommonly associated with stock market volatility not just in India but inother emerging economies as well.

According to K. Vaidya Nathan, investment banker and CEO ofQuantumphinance, FII flows into Indiawill continue to be good in the foreseeable future. "With other markets(the US and Europe) not doing well, money will pour in from FIIs.This year will see more net inflow in equities than 2010 which was more than2009. However, because the flows go in and out at short intervals, there may bevolatility."

Contrary to common perception, Rajesh Chakrabarti, aprofessor of finance at the Indian School of Business, Hyderabad, doesn't think that FII inflowshave created any bubble. "There was a fear after the US announcedits QE2 measures late last year that there would be a surge of liquidity intoIndian markets. That did not happen," he says. Adds Chakrabarti,"Price-earnings (PE) ratios are reasonable. The markets are neitherovervalued nor undervalued. I expect them to remain in this range for the restof the year."

Says Nathan: "Foreign flows are important but not somuch to override fundamentals."

For the first time since the recovery from the impact of theglobal financial crisis, the fundamentals of the Indian economy are lookingshaky. The latest Index of Industrial Production (IIP) statistics released forthe month of November 2010 show that industrial growth had slowed down to just2.7 per cent. At the same time, inflation was touching double digits with foodinflation almost at 20 per cent. A high inflation, low growth scenario is anightmare for any central bank. Governor D. Subbarao has said that the RBI is"desperate" to rein in inflation. That almost certainly points to aninterest rate hike later this month.

Chakrabarti does not believe that a rate hike will have anyshort-term impact on the markets. "The markets have already factored in a ratehike," he says. The real concern is what interest rates hikes will do tocorporate earnings and economic growth.

Nathan is worried about the longer term impact of higherrates on corporate balance sheets. "Higher interest rates will start tohurt Indian corporates." He also worries about what rising commodityprices will do to costs. "Commodity prices will increase even more overthe next nine months. There is a lot of investor money pouring into commoditymarkets. Large I-banks are offering customised OTC-structured products linkedto commodity prices to investors." Concludes Nathan: "With not muchupside on profit margins, PE multiples will start to look expensive in the nextnine months or so."

There are shades of the first half of 2008 in the first halfof 2011. The Sensex then, buoyed by strong economic fundamentals and impressiveforeign inflows, had scaled the peak of 20,000 for the first time in itshistory in January 2008, almost doubling from 10,000 in January 2007. Thiscoincided with a more generalised global economic boom.

Like in 2011, there was a massive surge in commodity pricesin the first five months of the year-the price of oil reached a high of $147per barrel in May 2008. This sparked inflation domestically and put pressure oncorporate profit margins. The RBI undertook a series of sharp hikes in interestrates over the summer of 2008 in an attempt to rein in inflation. This putadditional pressure on corporate profit margins. Incredibly, even as RBI washiking rates, the IIP for March 2008 was just 3 per cent and for May 2008 just3.8 per cent, mirroring the high inflation, low growth scenario that is beingwitnessed in early 2011. All this time, the Sensex reacted to the deterioratingeconomic fundamentals by sliding downwards from its peak of 20,000 in January2008 to 15,000 in July 2008.

This was well before the September 15 bankruptcy of LehmanBrothers and the onset of the global financial crisis, and so was driven moreby local than international factors, an important trend to note while analysingthe stock market in 2011.

In 2008, the final crash of the stock market to the 8,000mark was driven by the collapse of Lehman Brothers and a complete loss ofeconomic confidence globally. A crisis of that magnitude may not occur in 2011.But some are cautious. Says Nathan, "I am very bearish about thefundamentals in the US and Europe." Nandan Chakraborty, managing director,Institutional Equity Research, Enam Securities, worries about risks for theIndian stock markets irrespective of the direction that major economies in theWest take in 2011. "A fresh crisis in Europecould lead to a flight to safety from emerging markets into USdollar-denominated assets. In a different scenario, a strong resurgence of US growth could see FIIs move their investmentsaway from emerging markets to the US," he says. Kewalramaniagrees: "As the USeconomy slowly moves from a deflationary situation to an inflationary one,there will be pressure on the US Federal Reserve to hike rates or at the veryleast change their language on easy money. That may lead to a reversal of FIIflows from India."

There may yet be unexpected good news from the domesticpolitical quarter. In May 2009, The Sensex recorded an increase of 2,000 pointsin a single day, crossing the 15,000 mark, after the UPA's comfortable electionvictory. Says Kewalramani, "There could be another surge in February-Marchif the Government presents a good budget." Others are, however, not sooptimistic about its role.

Hemen Kapadia, CEO of Chartpundit.com, is wary about theimpact of scams. "FIIs don't like such an atmosphere," he says. Kirkireis worried about paralysis in decision-making. "The slowdown in decision-making in the Government would affect infrastructure spends," he says.

The optimists are not deterred. Says Prateek Agrawal,vice-president and head-equity, Bharti AXA Investment Managers: "We expect15 per cent returns in the next two-three months, 10 per cent around Diwali and20 per cent thereafter." Says Deven Choksey, managing director, KR ChokseySecurities: "It will be safe to assume that the Sensex will be above20,000 point level by the year-end."

In January 2008, few would have forecast the outcome forDecember 2008 any differently.

- with Mitali Patel

Courtesy: India Today