Are Indian stock markets 'scary'? - The 5 Minute WrapUp by Equitymaster
Investing in India - 5 Minute WrapUp by Equitymaster

Are Indian stock markets 'scary'? 

A  A  A
In this issue:
» After Facebook, now Twitter set to go public
» Why debt is dangerous...
» How should investors read the recent IIP numbers?
» Amid negative factors, good monsoons provide some breather
» ...and more!

Indian stock markets have been on a roller coaster ride lately. After plunging to sub-18,000 levels during the latter half of August 2013, the benchmark BSE-Sensex is back close to 20,000 levels. From the very bottom to the very top, it's a neat 12% rise in a short span!

Many have attributed the bounce back to the new RBI Governor, Raghuram Rajan. The rupee has also gained about 8% from the recent all-time lows.

How should you read this recent spurt in stock markets? In fact, that's a wrong question. The question should rather be- should you read too much into the recent optimism?

Our answer is no. For one, the 'Raghuram Rajan' effect has been overhyped. We respect him for his talent and the initiatives that he has announced. But to believe that India's long term problems have been addressed would be nothing short of wishful thinking.

Secondly, there has been some seemingly short term relief on certain external fronts. And the markets have found enough reason to cheer.

But does that mean India is out of trouble? If Jeffery Gundlach, a widely respected bond guru is to be believed, the outlook for Indian stock markets is negative. He thinks Indian markets are "very scary" in the medium term. Why so?

The answer is the risk of capital outflows. As you know, Indian stock markets are heavily driven by foreign capital flows. So anything that may cause foreign institutional investors (FIIs) to exit Indian stocks could bring Indian stocks tumbling. One big factor is any change in the monetary policy of major central banks. The US Fed had hinted about a likely tapering in its QE program starting September. If that happens, it could trigger a mass exodus of capital from emerging markets. And India would be among the worst affected.

A point to be noted here is that India has been a big beneficiary of the ultra-easy monetary policies of developed economies, especially the US. And hence the risk of capital flight in the case of change in monetary policy.

The point we want to drive across is that India is very vulnerable to external shocks. Any negative trigger could put the recent stock rally in reverse gear.

But this does not mean you keep away from Indian stocks. In fact, a market meltdown triggered by capital flight would be a great time to lay your hands on fundamentally sound stocks. For disciplined value investors, market meltdowns are always very exciting times. Because that's when there's too much fear and people are dumping stocks out of panic.

So what should an investor do? Which assets are worth buying now? How much should you allocate in different asset classes? We're sure you've been thinking through these questions. You may be looking for more specific answers. We completely understand your needs. And that is why we are taking steps to make The 5 Minute WrapUp more relevant to you. Watch this space for more details in the coming weeks!

What will be the most important factor driving Indian stock markets in the coming times? Please share your comments or post them on our Facebook page / Google+ page

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01:30  Chart of the day
The Indian economy has been witnessing one of the most severe slowdowns in several years. During the April-June 2013 quarter, India's GDP increased merely by 4.4%. This is the slowest growth rate since 2009. The slowdown in the economy coupled with high fuel prices and interest rates have had an adverse impact on the growth of the Indian auto industry.

In a bid to beat the slowdown blues, auto makers have been focussing on the overseas markets to boost exports. In addition, the foreign currency earnings would also help hedge higher cost of imports due to the depreciating rupee. The chart of the day shows the top 5 auto makers with the highest exports in terms of unit sales. These auto makers have reported robust year-on-year growth in their export sales.

Data source: Mint

In May 2012, the world's largest social networking site held its IPO. Facebook's IPO was the most awaited and perhaps one of the most marketed IPOs of all times. Ridiculous valuations were being accorded to it despite the fact that the company's actual fundamentals could not justify them. But the investment bankers responsible for it were selling the IPO on the popularity of Facebook. The performance of Facebook post the IPO was equally publicized since its shareholders ended up losing most of their investment. It is only recently that the stock was able to recover to levels that are close to the IPO value.

A little over a year, another social networking site has filed its papers for a public issue. This time the company is Twitter. Though the company has not disclosed the IPO value, the investment 'experts' have already started pegging its value in billions. One of its investors had valued the company at US$ 10.5 bn last month. So do the financials justify this huge value?

Unfortunately just like it was in the case of Facebook, the answer to this question also seems to be a big no. The company has filed its IPO papers under the cloaked option which is available to companies with revenues of less than US$ 1 billion. This way the company is not bound to disclose its financials till close to the actual sale date.

IPOs that give huge premiums to companies that have popular brands are not unique to just the US markets. We have examples of these in India too. But what investors need to understand is that the valuations and premiums have to be justified by the fundamentals. Because in the long run the stock price will reflect the fundamentals of the company. And if the fundamentals are weak, then the price would fall. And the only one who will lose in this scenario would be the investor investing in the IPO. Not the company. And certainly not its investment bankers.

The coming Sunday will be the day when the collapse of the famous US investment bank Lehman Brothers will complete five years. And in order to commemorate the same, The Economist is running a special series on the dangers of debt. Surely, the timing wouldn't have been better. It was indeed the excessive household debt in the US that led to the crisis and its huge aftermath.

As the article points out, as long as the financial-sector debt maintains its long term trend with respect to GDP, matters look fine. However, the moment the trend is exceeded by 10% of GDP, the chances of recession rise to about 40%.

It then argues how the deleveraging after the crisis, the act of lightening debt burdens, leads to the economy growing at a slower pace than before. So far so good we believe. However, the article then makes a big blunder by arguing that in order for the economy to recover faster, spending should be encouraged and interest rates need to be cut. We totally beg to differ. According to us, there should be no intervention in the economy and the economy should be made to heal by itself. Intervention is only going to make matters worse by providing temporary relief but creating bigger problems down the road. And it is exactly the replay of such a scenario that is our biggest concern right now.

The index of industrial production (IIP) number for the month of July is out. And to everyone's surprise the industrial sector grew by 2.6% YoY. Considering that in the previous two months the IIP numbers were discouraging, was the July figure a sign of revival or just an aberration? Before answering that question let us first understand what drove growth in the first place. Garment industry registered strong growth in July and was one of the key drivers for higher industrial growth. Capital goods segment also did particularly well, predominantly due to strong performance from the electrical machinery segment. In short, these two segments were responsible for higher growth in the month of July.

Now coming to the earlier question of whether this growth is sustainable or not. For one, the growth in capital goods segment is not a true reflection of the actual picture in the industry. Higher growth reflects better execution and says nothing about the ordering environment which is poor. Thus, if orders are not there in the pipeline future growth can come under pressure. Also, the growth of 2.6% should be seen in the context of base effect. Thus, it appears that the current growth in IIP is a mere eyewash. If this growth persists for a few more months than it can be said that India is on a path of recovery.

The last few months have seen all sorts of things going wrong for the Indian economy. The declining rupee, slowing GDP growth, rising deficit, etc. have led to concerns about India's growth prospects. But there has been light at the end of the tunnel. And this has been in the form of good monsoons. Indeed, as reported in the Economic Times, the monsoon in the period June 1-September 6, 2013 is 8% above its long period average (LPA). Even if the remaining September is somewhat below normal (and not totally wiped out), overall monsoon (June-September) could end up being 5-7% above the LPA.

This then would have a positive effect on the Indian economy given how reliant it is on monsoons. For starters, there will be a rise in demand for credit to buy seeds, fertilisers and farm machinery. After the harvest, the demand for several consumption goods in rural areas would also rise. Besides this, logistics, agro-processing and retailing would receive significant boost. The idea then for the government is to capitalise on this opportunity to introduce some reforms in the agriculture sector. This would be in the form of eliminating middlemen in the agri-chain and improving storage facilities so as to reduce wastage and supply bottlenecks. Effectively, this would also go a long way in dousing food inflation. But is the government upto the challenge? One will have to wait and see.

In the meanwhile, Indian stock markets are trading flat. At the time of writing, the benchmark BSE-Sensex was down by 15 points (0.08%). IT and consumer durables stocks were the biggest losers. Most of the Asian stock markets were trading lower led by Japan and Singapore. The European markets opened on a negative note.

04:40  Today's investing mantra
"Experience tends to confirm a long-held notion that being prepared, on a few occasions in a lifetime, to act promptly in scale, in doing some simple and logical thing, will often dramatically improve the financial results of that lifetime. A few major opportunities, clearly recognizable as such, will usually come to one who continuously searches and waits, with a curious mind that loves diagnosis involving multiple variables. And then all that is required is a willingness to bet heavily when the odds are extremely favorable, using resources available as a result of prudence and patience in the past."- Charlie Munger
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