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August Gale

The zoom, then came the correction. The bull will be tempestuous, at least for now.

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August Gale
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In the beginning of August, it seemed that the Indian bourses were witnessing a dream bull run. The BSE Sensex had already hit a historic high and was inching towards the 8000-point mark. A senior official in the Securities and Exchange Board of India (SEBI) even predicted it could be above 16000 points by April '06. Even before this statement, one of BSE's leading brokers, Rakesh Jhunjhunwala, shocked the investor fraternity by saying he saw the Sensex at between 20000 and 25000 points in five years' time. Most experts felt the numbers were optimistic but nonetheless, they were achievable.

Nothing, it seemed, could adversely affect the zooming Sensex. Not the Mumbai rains, not the fire at Bombay High oilfields, not even the fears of rising domestic interest rates. The bulls were on a rampage, the bears were running scared. But last week, the bulls seemed to have run out of steam. The BSE index shed nearly 300 points before recovering a bit. Everyone dubbed it the 'big correction' that was long overdue. Was it just that, or was there a deeper and more fundamental reason for the huge fall, which percolated down to a number of mid-cap stocks too?

To understand what happened in the past few trading sessions, look at the actions of the foreign institutional investors (FIIs), the sentiments echoed by global analysts and the new policies announced by theRBI  and the BSE. FII inflows were down to a dribble. That was critical because it was 'foreign money' that was largely responsible for the bullish trend. "Right now it's liquidity-driven rather than a dividend-yield market," says Abhay Aima, HDFC Bank's country head (equity and private banking). This year (Jan-Aug), India's share of FII investment in the Asian markets (excluding Japan) was one-third—or $7.3 billion out of a total of $22 billion. That propelled the sharp spurt (25 per cent) in the Sensex since May '05.

According to some estimates, a seventh of the free float in the Indian stockmarkets was purchased by the foreign investors in the past 12 months. As of last week, the FIIs held nearly 40 per cent of the total free float (which does not include shares locked in with promoters, domestic financial institutions or the so-called dead stock). So, when the foreigners shied away, the Sensex tumbled and went into a temporary tailspin. The moot questions: why did it happen and why did the FIIs book profits at this stage?

To search for answers, one doesn't need to go far. Just flick through some recent research reports released by leading foreign broking firms in the past week or so. All of them hinted that the Indians markets were overheated and at their peak levels, compared to other Asian markets. A UBS report stated that the Indian markets were overvalued by 28 per cent and within 4 per cent of being the most overvalued markets in the region, behind only Australia. Another study by JP Morgan contended that India was the third most expensive among emerging and Asian markets, ahead of even larger markets like Taiwan and Australia. Indian stocks are trading at 15 times earnings, compared to 12 in other Asian markets, making the latter more attractive.

Another worry for the FIIs is the high price-to-book values in Indian stocks, which has raised concerns that high returns on equity may not be sustainable. A Morgan Stanley report contended that "India's return on equity is likely to decline in the next one or two years." Indian stocks trade at a price-to-book value of 2.98, compared to an average of 1.83 for Asian stocks. All these would indicate lower positive returns in India. Morgan Stanley's emerging markets index was up 6.9 per cent this quarter, but its India index was up a lower 3.644 per cent.

So, while inflows into India are part of the general buoyancy in emerging markets, now that India is in the top valuation bracket, the flows may be directedelsewhere. As the Indian markets enter a period of consolidation and stabilisation after the frenetic activity in the past few months, other emerging and Asian markets, which now seem more attractive, could benefit before Indian markets see a renewed growth phase again. South Korea and Indonesia, which have already seen major corrections in their indices the recent past, may receive some of the FII flows.

Couple this with an additional apprehension that Indian firms may find it difficult to witness sharp growth rates in the near future. "A sharp rebound in corporate earnings from FY 2003 has translated into consistent earning upgrades. However, with the appreciation in share prices, we believe most stocks are now discounting high growth rates, implying that any near-term disappointments will raise the risk of significant corrections," stated a recently released CLSA report. Other analysts admit that companies which had seen 28-30 per cent growth in earnings per share could show only 24-25 per cent growth now. "Sustaining high growths on an already high base might be hard, so I think that might hit sentiments to some extent," says Priyadarshi Srivastava, research head at Niche Brokerage.

However, for some investors, these are only short-term concerns. For they believe in the long-term India story. "Yes, valuations are among the highest in the region, but so are earnings, profitability and the overall economic situation looks strong," says Karnail Sangha, a portfolio manager who manages Indian stocks for the Robeco group. Such investors think Indian stocks may be overvalued when compared to other emerging markets, but that's because the Indian markets now compare with others at the top of that heap. "Price earnings are on the higher side of Asian markets, they are getting to be comparable to larger emerging markets such as Brazil, Korea and Taiwan," says Andrew Holland, senior VP, DSP Merrill Lynch.

Despite high valuations, a mature, stable and a large market can still attract fresh funds. India-specific funds, particularly from Japan, are still being launched and pumping in money in the Indian bourses even at these high levels. "If we look at the macro story of India, there is consensus about the economic growth being maintained at over 6 per cent per annum over the next few years. And this can be matched by only a few countries in the world," says Sandeep Dasgupta, CEO, Deutsche Asset Management.

As JP Morgan's Asian strategist, Adrian Mowat, admits, "Should India have a videsh or a Bharat PE (price earning)? We think Bharat." What he means is simple. While foreigners may take a backseat as far as buying Indian paper is concerned, last week's correction may encourage Indian investors (including retail ones) to step in to fill the gap. "For the Indian households, with their low allocation to equities after years of volatile market returns and strong returns from bonds (or debt instruments), there remains a need to re-balance portfolios in favour of equities. We are at a very early stage of this trend," adds Mowat.

In this ongoing tussle between investors, who prefer profit booking at current levels, and those with a long-term outlook, everyone's still keeping a watch on the next quarter's corporate earnings. Analysts are openly saying they will prove to be crucial in deciding the future course of the Sensex. On the one hand, good monsoons have buoyed consumer spendings. But on the other, issues like rising global crude prices have had a negative impact. "For now, the market seems to be digesting the bad news. However, any visible impact on second quarter results (this fiscal) could provide the reality check," stated the CLSA report, as quoted in various newspapers.

Other flashpoints may come in the form of even higher crude prices with experts predicting a price of over $70 abarrel. This may impact both the overall economic growth as well as corporate earnings. In case the interest rates in the US rise above expected levels of 0.25 per cent every quarter, FIIs may withdraw monies from emerging markets. Bad news on the domestic front—finance minister P. Chidambaram has warned about the fiscal deficit situation—that will obviously impact investor sentiments. Not to forget that the Left parties could yet again prove to be party-poopers with their continued opposition to economic reforms.

In the interim, be prepared for a volatile Sensex that swings wildly. It'll go up, down or remain flat for no reason whatsoever until there's a certain clarity in the minds of the foreign investors or new domestic investors rush in to invest in equities. As Holland puts it, "You cannot expect the markets to move in a straight line." But you can definitely expect that at least over the next few weeks, the clash between the short-term negative India story and the long-term positive one will intensify. And the winners in this stock war will decide whether the Sensex touches new higher levels of 16000 or 20000 points or retreats back to older, lower levels.

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