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Stock markets: Arithmetic over optimism

Sep 17, 2004

After the rally that has been witnessed over the last few days, it appears as if the Indian stock markets are once again headed towards the dizzying heights they had reached during the early part of the year. However, before stepping into the rush, a check is in order. Let us try and find out what were the three most important reasons behind the stock market rally of FY04 and where do these parameters stand at the current levels.Valuations: During early 2003, until the time the rally begin to take shape, earnings seemed to have run well ahead of valuations. Backed by lower interest rates and aggressive cost cutting measures, while the corporates were slowly and steadily piling up profits, stock markets were not quite willing to award them the valuations they deserved due to bad sentiment prevailing at that time. Indian economy had just about managed to rake in a modest 4.4% growth and globally too, things were not quite upbeat, owing to events like the political turmoil in Iraq and SARS outbreak in select Asian countries. But when the reality dawned upon them, stock markets began their ride upwards and continuity of low interest regime and favorable monsoons further ensured that corporate earnings continued to remain robust. The consequence: Indian stock markets witnessed one of its finest runs ever.

But that was few months ago and today the scenario is vastly different. Owing to significant appreciation in stock prices, valuations are no longer as attractive as then from a near to medium term perspective. Further, rising inflation levels has led to interest rate concerns, two factors that have the ability to considerably stifle corporate earnings going forward. In view of these threats, caution has to be the order of the day and one will have to rely more on arithmetic than positivism.

FII inflows: While the rise in Indian stock markets did have a fundamental feel to it, no one can deny the role that FIIs have played in pushing up the prices. According to estimates, the foreign investors had pumped in close to US$ 7bn into the Indian markets in 2003 and the corresponding figure for the current year stands at an equally impressive US$ 4 bn until now. This by no means is a small amount and has been instrumental in taking the market cap of companies to the current high levels.

Now, what would be the future course of action of these FIIs? With interest rates on the rise in the US markets, these institutions would increasingly find it costlier to fund their Indian equity investments and secondly with valuations in the Indian equity markets having achieved sizeable levels, returns are not likely to be as attractive as before. So the possibility of these FII investments drying up if not being taken out cannot be denied. If the concern turns out to be true then the stock markets might witness considerable downside from the current levels.

India growth story: An economy growing at an attractive 6% rate and a population that is one of the youngest in the world. These two factors combine to make India one of the most attractive investment destinations in the world. While one would not deny the immense growth potential, still a lot needs to be done. Infrastructure is well behind other developing nations and still a large part of the populace depends on the vagaries of monsoon for its livelihood. Although, government's focus on rural development is laudatory, what will really put India on a higher growth trajectory is infrastructure improvement and a thriving manufacturing sector. Until then, some years we may achieve the 6% plus GDP growth and on other occasions we may miss it, depending upon the behaviour of rain gods.

After going through some key factors that have played a key role in affecting the stock market movement, we would like to point out that although the India growth story is not over, it is time the investor exercises caution. While across the board buoyancy is unlikely to happen in the near to medium term, the story has now become more stock specific. Invest in companies with strong fundamentals, proven track record with a long-term horizon in mind. Staggering your investments will also be a useful strategy.

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