You See, You Saw

• Investors borrowing from Bank of Japan got scared after it doubled the interest rates to 0.50 per cent
  
• There were continuing fears about a slowdown in the US economy that can lead to a flight of capital
  
• A meltdown in the Chinese markets led to apprehensions about a contagion effect in other Asian markets
  
• Locally, high inflation and interest rates led to a feeling about a slowdown in corporate earnings
  
• Market observers hint at price manipulation in 30-40 stocks, many of them newly listed after their IPOs
  
• With sentiments on the slump, now even minor bad news has the potential to lead to major corrections

***

Outlook

The Yen-Dollar Connection.

The Slowdown Fears in China and the US.

For investors, the nuances didn't matter. The sentiments were down. The problem was accentuated by the wildly fluctuating signals emanating from the iconic ex-Fed head. He said inflation was a matter of concern and that it was under control. He talked about a possible slowdown in the US economy and changed it to a probable moderate growth. Consumption indicators too have varied over the past few months. So, no one had any clue about what is likely to happen in the US this calendar year.

Dean Baker, co-director of a US-based independent think-tank, Center for Economic and Policy Research, explains "the stockmarkets had been acting as though the US and other economies would continue to grow at the same pace as they have been growing in the last three years." Now, it became apparent they could be wrong. Possibly, there was merit in the US slowdown argument.

Uncertainties are the bane of any stockmarket, especially those concerning the US economy. Inflationary fears in the US lead to a rise in interest rates, as has happened in India. This is because most central banks feel that by hiking interest rates, they can curb the money circulating in the system—as people will be less prone to borrow—and control prices. This is what the Reserve Bank of India has done to stall rising property prices. Thus, interest rates have risen sharply in the US—except in the recent past.

The combination of a slowdown and higher interest rates in the US can force global investors to take their monies out of emerging markets and invest in the US. For, most foreign inflows into emerging markets, including India, either come from the US or are dollar-denominated, and the returns in the US debt paper become more attractive, thanks to the higher interest rates. The combination also squeezes out the money available to invest in emerging markets.

Couple the US situation with what happened in China. Dudley Jr says the Shanghai index had jumped 130 per cent in the past 14 months, and "the Chinese government had good reason to fear that a speculative bubble was forming" in that market. Adds Shroff: "Investors may have been concerned about an overheating Chinese economy, and the inability of the government to contain lending and investment growth." The time was ripe for a meltdown in Shanghai, which happened on February 27.

It immediately brought back fears of a contagion effect in Asia, as the same had happened after the market crashes in Thailand (1997) and Russia (1998). In both cases, almost all the Asian stockmarkets had slumped in the aftermath. To cut down possible losses, global investors sold equities to take money out of Asian markets. This led to an all-round fall in Asian indices, and impacted others like the US and Japan.

Domestic factors. In India too, both inflation and interest rates have gone up in recent times. The government's efforts to control prices have led to a feeling that this may impact future corporate earnings and, hence, valuations in the stockmarkets. Take the case of the cement sector. The finance ministry's insistence that cement firms should reduce prices are obviously being seen in a negative light by investors. Many institutional investors think that it's a "fundamental mistake" to have such price caps.

nfortunately, corporate earnings have shown signs of slower growth. Agrees I.V. Subramaniam, CEO, Mumbai's Quantum Advisory Services: "Earnings growth in 2008-09 will be a lot slower than in 2007-08." While the combined incomes and profits after tax of the 50 Nifty stocks rose by 13.4 per cent and 32.4 per cent respectively in Q2 2006-07, vis-a-vis the previous quarter, the growth rates were a mere 1.8 per cent and 2.9 per cent, respectively, in the next one.

Thanks to a slowdown in earnings, investors are re-evaluating their risk-reward ratios. This becomes critical when interest rates go up. Agrees Subramaniam: "With money becoming costlier now, people are factoring in risk." Adds another Mumbai-based broker, "I have seen that there's a thinking among high-net worth investors that equities will give them 12-15 per cent returns, and since one can get 8-10 per cent from fixed deposits, there's no point in taking a risk with equities."

Price manipulation. The Indian market regulator, SEBI (Securities and Exchange Board of India), came out with an interim order (dated February 22) that there was manipulation in the Atlanta scrip, whose price had zoomed from Rs 192 (after being listed) in September last year to Rs 1,259 by mid-December.SEBI found that two market operators—Manish Marwah and Dilip Nabera—were responsible for this rise.

Market observers hint there have been similar manipulations in 30-40 other stocks, many of them that were newly listed after their IPOs. After SEBI's order on Atlanta, many of the manipulators started cashing out—or selling their portfolios—on fears that the market regulator was about to launch a detailed investigation into price movements of all these stocks. This added to the softness in the Indian stocks.

Therefore, it's clear that a number of factors were responsible for the current round of correction, and the subsequent volatility in the Indian markets. There's also a growing feeling that since valuations are really stretched—and they were possibly the highest in India—the Indian markets have entered a phase where even minor bad news can bring the indices down by a few hundred points. This is different from the one in 2005-06 when even the worst of the bad news wouldn't affect the optimistic sentiments. It's probably time to switch on your TV, tune in to a business channels, listen to the news carefully, and monitor the scrawlers too.