Mount 16K scaled. What next?

The most important factor fuelling the current rally is the high level of liquidity,not just in India but across the globe. This liquidity tsunami is the consequence of all major central banks lowering interest rates and governments injecting massive doses of fiscal stimuli to stave off recession. Liquidity has found its way into various asset markets,including equities and commodities,raising prices.

In the leading economies of the West,both economies and markets appear to be stabilising. Demand has revived to some extent. However,both the US and European economies are still hobbled by high rates of unemployment. Nonetheless,with their home economies stabilising,foreign institutional investors’ (FIIs) risk appetite has improved. And with India being the world’s second-fastest growing economy,it is not surprising that a large portion of the emerging-market allocation has poured into this country.

According to Jayesh Shroff,fund manager at SBI Mutual Fund,“The real game changer in this rally has been FIIs pumping money into QIPs (Qualified Institutional Placements) and the secondary markets.” The net inflow of FII investments into Indian equities this calendar year has been $8.75 billion.

Destination India

What enabled India to escape the worst fallout of the global economic crisis was an economy that is primarily reliant on domestic consumption (and not on exports). Moreover,with the general elections yielding a stable government at the centre,policy reforms are expected to take place at a faster pace. Industrial recovery has also been much faster than expected as is evident from the index of industrial production (IIP) numbers of 8.2 per cent in June and 6.8 per cent in July. All these factors are expected to keep India at the top of the heap of desirable investment destinations.

Risks to Indian stocks

The single most important factor driving the markets is excess liquidity. Says Shroff: “This surfeit of liquidity has led to all asset classes — oil,gold,commodities and equities — moving up. This excess liquidity is likely to cause a surge in inflation. To counter that central banks will have to start monetary tightening. It is not so much a question of if as of when.” And when liquidity gets sucked out,asset prices,including that of equities,will take a knocking.

Another risk arises from the poor monsoon which,despite the recent surge,remains 20 per cent below normal. The drought is expected to stoke food price inflation which could result in a broader inflationary phenomenon. The central bank would then have to tighten rates earlier than it otherwise would have done. Higher interest rates would in turn have an adverse impact on economic recovery,corporate profitability,and ultimately,on stock market performance.

Moreover,throughout the recent global financial crisis,robust rural demand played a major part in shoring up the Indian economy. This source of demand can’t be counted upon hereafter in the wake of a poor monsoon. However,only agriculture GDP is likely to be affected by the drought; manufacturing and services,which are already recovering,are likely to remain largely unscathed.

Yet another negative is the government’s double-digit fiscal deficit,which is likely to exert pressure on bond yields and prevent interest rates from softening.

Global economic events are another source of risk to the Indian markets. According to Anup Bagchi,executive director,ICICI Securities,“A significant bank failure or a failure of the expected economic revival to come about would lead to risk aversion and a pull back of liquidity to the developed world,adversely affecting the Indian markets.”

And finally,the current economic buoyancy arises from the government’s fiscal stimulus packages. But the government can’t inject more money,given its parlous fiscal situation. Hereafter,private spending will need to take up the slack. Says Huzaifa Husain,head of equities,AIG Global Asset Management: “It is imperative that private demand — both consumption and investment — picks up in the near term. The rate of growth of these drivers of demand has dropped dramatically. Infrastructure-related investments in particular need to increase. If delays happen on this front one may see economic growth rate become lacklustre,causing a drop in earnings and thereby the markets.” He further adds: “Markets discount future expectations. At present they are discounting a healthy recovery — local as well as global. We are hesitant to conclude that full recovery has happened.”

Fairly valued or overvalued?

Forward earnings per share (EPS) and PE estimates for the Sensex vary among various market participants. Shroff of SBI MF estimates FY10 EPS at Rs 880-890 and FY11 EPS at Rs 970-980. Bagchi of ICICI Securities estimates Sensex EPS at Rs 905 for FY10 and at Rs 1,040 for FY11. Mayank Shah,chief executive officer of Anagram Capital,estimates Sensex EPS for FY10 at Rs 910 and for FY11 at Rs 1,000.

As for whether the market has become overvalued,again opinions vary. Says Shroff: “At 18x it is overvalued compared to its historical average valuation of 15-16x. But then times have also changed,so I would not call it an overvalued market.” He further adds: “Both the economy and the markets have surprised us positively. If the numbers continue to improve,EPS estimates will get revised upward. Then the markets will swing back from a fairly-valued zone to an undervalued zone.” He concedes that the markets are likely to remain volatile.

Bagchi too believes that at 16,200 the market is fairly valued at 18x its FY10E earnings and 15.5x its FY11 estimated earnings.

Shah,however,believes that the Indian market is no longer cheap. “Most large-cap stocks are fairly valued. Among mid- and small-cap companies you may find undervalued stocks,” he says. According to him,a correction can’t be ruled out. “In the last 10-12 days India has received about $1 billion. This is momentum money. If the expected appreciation in stock prices does not happen this money will fly back.”

What should investors do?

Bagchi suggests that investors should buy stocks on significant declines in the markets as opposed to selling into rallies as he believes that the positive election results and an improving global economic scenario will enable the Indian markets to command a premium valuation vis-à-vis peers. According to him,while the broader indices may trade within a range,the action is likely to shift to quality mid- and small-caps,which,he believes,have the potential to deliver better relative returns in future.

In consonance with his view that the markets could correct,Shah suggests that investors should shift to a more defensive portfolio comprising FMCG,frontline IT,and oil marketing companies’ stocks. “Your portfolio will then not deteriorate in line with the markets if there is a sharp correction,” he says.

For those who invest in equities via mutual funds,Husain suggests systematic investment plans (SIPs). “Time and again it has been proven that predicting the markets is fraught with danger. Yet it has also been proven that equity investments over a period of time provide good returns. To take care of volatility and yet participate in the growth of the economy we would advise investors to do an SIP. The past two years have been volatile. If one looks at Sensex returns between August-end 2007 and August-end 2009,the returns are barely 2.3 per cent. But if one had done an SIP for these two years,the total appreciation would have been 16 per cent over this period in absolute terms,” he says.

With the markets trading above their long-term average valuation,till earnings improve further,investors ought to get cautious.

sk.singh@expressindia.com