Does This Indicator Tell Us the Sensex is Headed for a Correction? - Vivek Kaul's Diary
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Does This Indicator Tell Us the Sensex is Headed for a Correction?

Aug 3, 2018

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India is no longer immune from developments in the global world.

And we not talking about just the economy here, but also the financial markets.

In fact, history has time and again shown that Indian stocks are greatly influenced by foreign money flows.

When foreign portfolio investments (FPIs) make their way into equities, the market goes up. But the reverse also holds true - when FPIs catch a cold, India also sneezes.

Of course, FPIs are not the sole movers of our market. Domestic mutual funds also big players.

But the role played by FPIs in the Indian markets cannot be undermined.

So, what influences foreign flows in and out of India?

  • Interest rates - both the RBI and the US Fed
  • Health of the economy
  • Indian politics
  • State of the Asian economies and markets, particularly China

Let's take interest rates for example. Let's go back to 2008 and see how the scenario played out during the global financial crisis and its aftermath.

Once the global crisis unraveled in late 2008, financial markets across the world suffered a massive meltdown. India was not spared either.

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FPIs pulled money out of equities to the tune of Rs 477 billion in FY09. The Sensex fell around 38% that financial year.

Mind you, at the time, the Indian economy was not doing badly. For instance, the GDP growth in FY08 was around 9.3%. It did fall to 6.7% in FY09, but the growth was still decent. So the fall in the Sensex was largely a result of the plunge in global markets.

Post the crisis, the US Fed went on a massive easy money spree. US interest rates hovered close to zero. Little wonder, foreign money went scouting for better yields elsewhere in the world.

And India caught their eye in a big way.

Indeed, while FY09 saw Indian stocks down in the dumps, the recovery in FY10 was remarkable.

In the years FY10 and FY11, the Indian economy was going great guns, and foreign money, which had fled in FY09, made a beeline for Indian shores once again to ride the India growth story.

The chart below displays this clearly.

What is the Relation Between Foreign Money and the Sensex?

There was a lot of fund inflows in FY14 and FY15 too largely fueled by the Modi euphoria. And not surprisingly, the Sensex also posted decent returns during these years.

Which brings me to the fund flow activity we have been seeing in the last few months. We are barely three months into FY19, and there has been quite a bit of foreign fund outflow in these months. The Sensex has gained 14% in the year so far but this can be attributed to only a handful of stocks.

Meanwhile, the US Fed has been gradually raising US rates. The yield on the 10-year Treasury touched 3% recently.

So the million-dollar question is - If the US Fed continues its hawkish stance, will FPIs keep pulling out money from the Indian market? In which case, are we looking at a likely correction in the Sensex?

Here's Vivek's views on the impact of fund flows:

  • On the whole, FIIs will continue to exit India, as the era of easy money comes to an end. At the same time, it is worth remembering that the American dream, which is basically a consumerist one, runs on low interest rates. This is something that the Federal Reserve will have to deal with in the second half of the current year, where it will have to make a decision of whether it will allow the American interest rates to continue to go up or not.

How does all of this impact you, dear reader?

How Should You Look at Foreign Flow Activity While Picking Stocks?

When looking to invest in equities there are two essential factors you need to look at - the strength of the business and the valuation of the stock.

FPIs flows don't have an impact on the businesses per se. They don't influence strategic decisions, the running of operations, and the financials of companies.

Where they do have an influence are valuations. In a bull run, as more foreign money finds its way into stocks, PE multiples can expand to exorbitant levels. Indeed, there are quite a few stocks whose PE multiples have always consistently been high - upwards of 40x.

Buying stocks of companies at such valuations do not make much sense unless you want to take on the dangerous game of speculation on the next FPI moves.

Having said that, let's look at the reverse scenario - FPIs pulling out money. This is bound to lead to some sort of correction in the Sensex. We don't know when this will happen.

The point is that things could get worse before they get better. And when it does, it will be a boon to value investors if such a correction brings down valuations to reasonable levels.

Like I said earlier, FY19 has started out with more foreign outflows than inflows. If the Fed continues its hawkish stance, the outflow will likely continue. A correction in the Indian indices then cannot be ruled out.

That will become the perfect opportunity for investors to start buying not only quality stocks that are cheap but also stocks that can sidestep the challenges facing the Indian economy, which Vivek has been consistently pointing out.

In this context, one of the key risks that Vivek has been continuously highlighting is the bad loan problems plaguing India's banks, especially the public sector banks. While I acknowledge this issue, after much scouting, I could still zeroed -in on a finance company that is not afflicted by the ills plaguing its bigger PSB peers.

It's a recommendation that I just shared with The India letter subscribers this week.

Stay tuned for more.

Regards,

Radhika Pandit
Radhika Pandit (Research Analyst)
Editor, The India Letter

PS: When the markets nosedive, that's the best time to put wealth building in motion. Small caps are crashing - that only means there is more opportunity than ever to buy them up - get our market-beating small caps recommendations here.

Radhika Pandit (Research Analyst), is the Editor of The India Letter and is one of our senior analysts with more than a decade-long stint in the field of equity research. She has helped build our pharmaceutical sector research from scratch and has a firm grasp of the Indian automobile industry. Being an ardent follower of Warren Buffett's value investing philosophy, she believes in investing in solid businesses for the long haul.

Disclaimer: The views mentioned above are of the author only. Data and charts, if used, in the article have been sourced from available information and have not been authenticated by any statutory authority. The author and Equitymaster do not claim it to be accurate nor accept any responsibility for the same. The views constitute only the opinions and do not constitute any guidelines or recommendation on any course of action to be followed by the reader. Please read the detailed Terms of Use of the web site.

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1 Responses to "Does This Indicator Tell Us the Sensex is Headed for a Correction?"

Anand

Aug 3, 2018

Foreign Institutional investors have been relentless sellers in the Equity markets for the last so many months. In spite of that the Markets have gone up. Would like to understand from you, what further selling by them in your opinion is likely to bring the markets down?

Seems to be an outdated view by the writer especially considering that domestic institutions have countered the fiis on almost on all days when they were sellers.




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