The markets disappointed investors on the first trading day of the week, leaving little opportunity to exit as the indices fell like ninepins. However, yesterday was a different story altogether and the markets recovered all of Monday's losses and even extended gains beyond that. However, overall, investors were disappointed towards the end of the year, as on Monday itself, they lost hope of seeing the benchmark index at 10,000 by the end of calendar year 2005, which was predicted by dime-a-dozen people.

In our view, had the indices crossed this five-digit figure, it would have been quite a feat, for the simple reason that even at the current juncture, valuations look stretched in numerous index stocks. Going forward, in order for valuations to support stock prices, companies need to have sustainable and profitable growth. Here are some of our concerns, with the indices hovering around their all time highs.

Valuations
Valuations for large cap stocks seem slightly stretched and in our view, prices of most of these stocks have already factored in future growth, some of them even for the next two years. It must be noted that the average price to earnings multiple of the Nifty index is currently 18.6 times, which means that the indices are reasonably valued, considering the historic trend. Hence, it means that prices paid for stocks are much more than what they are worth and therefore, investors will back off, at least in theory. Experts who do not want to call a 'spade a spade' are now commenting that the index is neither undervalued nor overvalued. While we do not understand what that means, i.e. whether it is a signal to buy or to sell, what it reflects is the fact that no one wants this dream run to end!

Crude Prices
India imports 70% of its crude oil requirements and it must be noted that every US$ 10 increase in oil prices knocks off about 0.4% from the GDP growth rate during the following four quarters. Yet, thanks to subsidies and the left parties, Indian consumers have been protected from the huge surge in oil prices and are not yet feeling the pinch completely. The best reflections of this are our very own oil PSUs, who continue to reel in the red. However, it is indisputable that there is a limit to which the government will take the hit and if even a part of the burden is passed on to the consumer, then inflation will surge and will certainly slowdown economic growth.

Fiscal Deficits
The total fiscal deficit of the state governments and the central government combined is over 10% of the GDP and it continues to go up. Continued economic growth and control over public finances are necessary to keep the government's balance sheet under check. Given the sharp rise in crude prices, in the first half of the current fiscal year, the fiscal deficit has already gone beyond budget expectations. We will soon see this impacting liquidity in the domestic market (this is because both the government and the corporates will borrow more). Interest rate outlook continues to remain cautious, with signals of it going northwards.

In conclusion, there are two schools of thoughts here. Some say that the Indian economy is in the midst of a fundamental shift. The other school of thought says that this rally is purely liquidity-driven and that the day FIIs wake up, investors are likely to lose sleep. In our view, it is clearly a case of demand-supply mismatch. India is the hottest destination for investments and tons of FIIs have lined up huge investment plans for India, running into several billion dollars. A lot of them have India-dedicated funds and everyone wants to benefit from our growth story. But remember, if you are filling air in a balloon, it can expand only till a certain limit, beyond which it bursts! Having said that, we remain positive on the long-term India growth story. Happy New Year!