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Key risk for stockmarkets?

Mar 15, 2005

There are two developments that have been time and again making to the headlines of Indian business newspapers since the last few months. These are 'New highs for Indian stock markets' and 'Record FII inflows'. Well, actually, the above should be in the interchanged order as the consistently robust Foreign Institutional Investors (FIIs) inflows have been pushing the Indian stock markets to higher territories. However, with every rise, there is a heightened risk for investors, as markets cannot move in a single direction for 'eternity'. Considering this, we conducted a poll on our website wherein we asked our viewers, "At the current juncture, what is a key risk for the stock markets?"

The results of the above poll did not come as a surprise to us, which shows that investors believe 'FII outflows' to be a biggest risk for Indian stockmarkets at the present. 51% of the votes were garnered by this option. This was followed by 37% votes to 'high expectations' and the balance 12% to 'politics'. We throw some light on each of the above in brief.

FII outflows: The concern with respect to 'possible' FII outflows stems from the fact that FIIs have pumped in huge amounts of money into Indian equities since 2003. After the record-breaking inflows of US$ 6.5 bn (2003) and US$ 8.5 bn (2004), these have been much stronger in the current year to date at US$ 3.3 bn already. As mentioned in our earlier articles, one key factor that has been attracting foreign money into the country is the strengthening Indian currency against the US dollar. Or, to put it better, the weakening dollar against the Indian rupee.

For FIIs, investing in US currency denominated assets is not a relatively lucrative option considering the widening US trade deficit gap, low interest rates and a jobless US economic recovery, which could further put downward pressure on the US currency. On the other hand, their investments would not only reap the benefits of strengthening Indian currency but they would also gain from the strong prospects of Indian equities, which is improving on the back of better cost efficiencies, higher productivity and strong consumption led domestic growth.

So, where is the risk here for Indian equities? The risk arises from the fact that US interest rates are on the rise. After having risen from 1% to 2.25% in 2004, these are expected to rise to about 3.5%-4% as has been indicated by the US Fed authorities. In such an event, investment in US bonds and government securities would become relatively attractive (and safer) for FIIs compared to the prevailing scenario. Then, there would not be a strong case to maintain high investments in developing countries like India. However, while we do not foresee a reversal of FII inflows in the near to medium-term, a considerable slowdown of the same cannot be written off. It must be noted that domestic equity investments are in no way sufficient to meet the shortfall.

High expectations:This is the characteristic of any bull market. Investors start to believe that the strong performance of equities would continue for years to come (not that they cannot) and the stock prices would continue to give mind-boggling returns! However, what investors need to be cautious about here is from investment advise/calls in those sectors/stocks where only the assigned valuations have been increased without a corresponding increase in earnings. This is because valuations of a sector/stock do not change, or rather should not change, with market sentiment.

Valuations warrant an upgrade or a downgrade only if there is a fundamental change in the core business of the company. Investors need to understand that in the long term, fundamentals and not expectations guide stock prices. This fact has been proved time and again. Though there may be short-term volatility, as traders get in and out of stocks, hold on to fundamentally sound companies. They are surely to realise their worth sooner or later.

Politics: While considering the top-down approach of investment, politics is rated next only to economy, which is at the top of the ladder. In fact, the importance of politics (read good government) can be gauged from the fact that government policies have a very strong impact on the performance of all the three constituents of a country's output - agriculture, industries and services - which is consequently reflected in the stock price. Policies affect investment decisions - both by international and domestic investor community - as they would be wary of losing their investment (or not making sufficient returns) in the event of economically unfavourable policies.

Thus, after having gone through each of the options in a little detail above, we believe that at the current juncture, FII behaviour remains one of our key concerns. Considering that a large chunk of the FII monies coming into Indian equities is part of hedge funds, it makes us want to be more cautious. After all, hedge funds are known for their 'fair weather friendship'. However, apart from keeping a close watch on the movement of US interest rates, investors would also need to tone down their expectations from equities from hereon. As far as politics is concerned, while the current government has been accepted well by investors, a close eye needs to be kept on the ruling governments allies also. However, to conclude, in order to hedge the impact of the above risks to some extent, there is a need to invest in only fundamental sound companies.

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