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Investing: Sentiment(al) or fundamental?

Sep 2, 2005

What is it that drives stocks, or rather, stock prices? Looking at it from a purely economic point of view, stock prices are no less than normal goods, where the demand and supply equation determines the price. The greater the demand for a particular stock, the higher its price will go. On the other hand, the greater the supply of a stock when there are a greater number of willing sellers in the market, the price will reduce. The demand-supply equation, on the other hand, is determined by the fundamentals of the company in question, the integrity of its management and future growth prospects. For example, if the company has strong financials, has a management of great vision, is a market leader in its field and has strong business prospects, market participants will want to own that stock, demand will be higher and as a result, over a longer period of time, the stock will appreciate and give good returns to investors, provided it has been consistent in its performance.

However, apart from fundamentals, there is another factor that influences stock prices. This is the 'sentiment' factor. This is dependent upon numerous forces, like the current state of the economy, oil price movements, stock market movements in the region, geopolitical factors, key events, such as the Fed meeting to decide interest rate policy and so on. However, it should also be understood that sentiment is affected by reports about Foreign Institutional Investors (FIIs) inflows as well. In the Indian market, particularly, this gains significance, as it is the FIIs who have been the pump primers of this current market rally. In this write-up, we examine how sentiment has lifted stocks up into stratospheric territory and debate as to whether this is sustainable or not.

Up it goes!

The major indices have been on a virtual one-way trip over the past few months. It is no secret that the FIIs have been the major drivers of this rally. This has been driven by the fact that interest rates in the US are low, making it and most other developed economies as well, unattractive to invest in. The 'India story', on the other hand, is now globally known and fund managers and FIIs, desperate in search of better returns, have poured their money into emerging markets and none less than India.

Global liquidity and higher risk appetite have also been factors that have resulted in peculiar events occurring around the world. For example, US fund managers have invested in oil as a sort of hedge, due to low returns in the US. This is an example of speculation occurring in oil, which has been part of the reason for oil hitting its all-time highs. This liquidity has been due to low interest rates in not just the US, but many other economies around the world as well, including the EU and UK. Thus, this massive liquidity has found its way into oil as well as stock markets and property markets around the world, including India.

The massive net FII inflows (at last count US$ 7.4 bn), on the other hand, have resulted in sentiment on the street soaring and the resulting mania is nothing but 'irrational exuberance'. Do not get us wrong. It is not that we are bearish on India. We are very optimistic about the prospects of India Inc, but simply feel that the current levels of stocks across sectors leave very little room for further appreciation. The downside risk is clearly much more than the upside potential and the risk-reward ratio is skewed in favour of risk.

So what should an investor do?

Sentiment, thus, is largely a short to medium-term driver of the markets, with fundamentals taking over in the long-term. There is a lesson to be learnt from this. It is that one cannot time the markets. This is something even the great Warren Buffet has been unable to do, preferring instead, to focus on long-term growth stories. In the short term, markets move based on news flows and sentiment. Thus, trying to 'buy at the bottom and sell at the top' is something that is more easily said than done. Strange as it may sound, equities are a unique asset class, where it is easier to predict where the market will be 2 or 3 years down the line, than where it will be 2 or 3 months down the line. It is just not possible to predict short-term events like 9/11 or a terrorist attack on a major oil pipeline. It is certainly easier and safer to predict long-term earnings growth for a company. Over a long period of time, stock prices will track corporate earnings, albeit it may not be in a linear fashion.

Of course, one must consider macro and sector-specific risks before investing. Macro risks could include factors like higher interest rates in the US, causing capital flight from India and affecting the markets. The possibility of the bursting of the property bubble in the US also exists, which would seriously limit the spending capacity of the already stretched US consumer, the major growth driver of the global economy on the demand side, up to his or her neck in debt. Long-term risks for certain sectors could include:

  • Risk of currency appreciation for software companies, thus, adversely affecting their margins;

  • Downturn of the steel cycle, resulting in an adverse impact to steel companies;

  • Spiraling crude oil prices, which is already happening, causing a hole in the balance sheets of oil marketing companies and also affecting the CV and passenger car industries, and

  • Risk of poor monsoons, causing a blow to the fertiliser, FMCG and tractor industries, which are dependent on the rural markets to a great extent.

Always take into account all possible factors affecting a company or sector before making an investment decision. After all, it is your hard earned money that you are investing and it is definitely not worth losing just because of 'negative sentiment' prevailing in the stock in which you invest!

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