Markets likely to be volatile in short to medium term

The recent volatility shows how vulnerable Indian stock markets still are. A $1-billion outflow from foreign institutional investors (FIIs) in the first 10 days of May has created panic in the market that saw the Bombay Stock Exchange's benchmark Sensex drop below 27,000 for the first time in 2015. Since touching an all-time high of 30,024.74 on March 4, the Sensex slipped 12 per cent to a low of 26,423.99 on May 7, a level last seen in October 2014. And analysts say investors will have to live with market volatility in the near term due to a lack of positive developments.

"This [investor behaviour] is not new to Indian markets. Even a small sell-off creates panic and all of a sudden everyone feels it's the end of the tunnel," says I.V. Subramaniam, Managing Director and Chief Investment Officer at Quantum Advisors. "The reality is that not much has changed since the general elections last year. This has made investors nervous and they are evaluating whether they should hold on in a market where many stocks are trading at 25-30 times [price-to-earnings ratio] when there is strong anticipation of a rise in US interest rates," he says, referring to concerns that rising bond yields in the US could prompt FIIs to pull out money from Indian equities.

Fund managers say muted growth in corporate earnings also led to caution among investors. "Corporate earnings have not been up to the mark and, as a result, equity markets have witnessed healthy consolidation," says Sankaran Naren, CIO of ICICI Prudential Mutual Fund. Gopal Agrawal, CIO at Mirae Asset Management, concurs. "It will be a while before corporate earnings start regaining momentum," he says.

Foreign portfolio investors are the lifeline of Indian equity markets and the direction of FII flows decides the course of the market. While FIIs have been booking profits in view of the bull run, the uncertainty over FII taxation is another major reason for the sell-off. The income-tax department had earlier sent notices to several FIIs demanding minimum alternate tax on capital gains made by these investors. The government has now set up a panel headed by Law Commission Chairman A.P. Shah to examine the matter, providing a breather to the FIIs.

Unlike the FIIs, domestic mutual funds - flush with cash following heavy inflows over the past year - have been buyers in the falling market. However, other participants such as insurance companies and retail investors have yet to take a plunge into the market. Agarwal of Mirae Asset says that, in the recent market fall, he has exhausted his entire cash position to buy stocks in banking, cement, logistics, pharmaceutical, construction and capital goods sectors. Naren of ICICI says the fund house used the opportunity to reallocate and rebalance its portfolios across all its equity schemes. "A cyclical revival will eventually happen. As a result, cyclical sectors like infrastructure and financials could do well in the long term."

Market participants say that, despite the recent drop, India is in a much better position than before as there aren't any structural problems but only administrative ones. Analysts say the Indian economy is moving in the right direction, but it will take some time to get the desired results. For instance, the government plans to spend four times more than last year on building roads. Similarly, the situation is improving in coal and iron ore sectors where mining is expected to begin soon. In the power sector, state-run companies have started giving orders for electrical equipment. In March, the Narendra Modi government managed to pass three bills - the Insurance Amendment Bill, and the controversial coal and mining bills - by garnering support from a combination of opposition parties in the Rajya Sabha, where it lacks a majority. "Irrespective of the rise and fall in the market, the broader story remains intact as India is a recovery mode," says Agrawal. "Soft commodity prices and government policy will be the key drivers for India. Going ahead, the strategy remains the same - buy on dips."

Naren of ICICI sees 2015 as a year of investment. "One should incrementally invest for the long term as and when such opportunities appear. Volatility may continue in the near term till earnings remain muted, credit growth is low, the capex cycle does not revive and banks do not transmit lower rates to borrowers."

The key triggers for the market in coming months are the monsoon, the Reserve Bank of India's monetary policy, April-June corporate earnings and important bills pending in Parliament including on the Goods and Services Tax and land acquisition. Subramaniam of Quantum says investors, especially foreign investors, must temper their expectations. "India can't deliver a sustained 8 per cent growth, but it can record an average 6.2-6.5 per cent growth. Also, with subdued earnings growth in the near term, markets cannot sustain the high valuation," he says. "There is nothing to suggest that one should pay very high valuations to buy stocks."