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Stock market: Is the worst over?
Smart Investor Team
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January 28, 2008

Time and again, in the past four years, the markets have corrected and soon bounced back, only to confirm that India's secular bull run continues. However, this time around, the market's fall seems to be a bit different, for the fact that the fall is quite steep in absolute terms.

In a matter of seven trading sessions, the S&P CNX Nifty fell 21 per cent or 1,388.55 points (from 6,200 on January 11 to 4,899.30 on January 22). During the same period, the BSE Sensex lost 4,097.51 points or 19.67 per cent.

Although it has recovered about 40 per cent of the losses, in hindsight, there aren't many reasons that come as a surprise for the fall. For one, during October 15, 2007 to January 1, 2008, out of the 33 global indices (representing Americas, Europe and Asia), only 4 were up and, that too, marginally by under 5 per cent. Among losers, many reported double-digit losses (maximum was 16 per cent; China's Shanghai composite was down 12.7 per cent).

On the other hand, the Indian markets were up - Nifty was up 6.52 per cent and Sensex by 8.36 per cent. The outperformance came at a time when the corporate earnings growth was apparently slowing down.

The reason for global markets sliding was mainly due to the crisis in the US, including the sub-prime issue and a looming threat of a recession, which in turn is bad news for most global economies, as many of them are big exporters to US.

In India's case, the market seemed to be believing that the country could withstand the storm as the domestic economy would be the least affected given its low trade exposure to the US (as a percentage of GDP growth), which meant little impact on corporate earnings, and thus, share prices. But, most experts don't agree with this decoupling theory anymore.

Says Gul Teckchandani, Investment Advisor, "I don't agree with the decoupling theory. It doesn't work selectively. India is coupled with the world. As far as the sentiment angle is concerned we are coupled, but not much from the business angle."

Ridham Desai, Managing Director, Morgan Stanley says, "If the world suffers a US recession-led sell off, we do not think Indian equities will be able to decouple, at least, in the short run. The good news is that as and when the valuations correct on the back of such a sell-off, Indian equities could outperform emerging markets helped by India's long-term structural story, RBI's comfortable liquidity position, a benign political environment, a successful soft landing in economic conditions and strong corporate balance sheets."

Even if one assumes that India were to remain largely insulated from the business point of view, it is still vulnerable to the movement in global investment flows. The market appears to have forgotten that the rise in Indian markets so far has largely been driven by foreign flows, which have not come in so far, in 2008.

In fact, FIIs have sold stocks worth Rs 12,093 crore (Rs 120.93 billion) in the cash segment, while they were net buyers of Rs 4,422 crore (Rs 44.22 billion) in the derivatives market between January 1 and January 24, 2008.

Additionally, there were many pockets in the market that were overvalued. Adds Teckchandani, "The markets fell because of the excesses and speculation." The highly leveraged positions of many market players were also among the crucial factors responsible for the crash.

R Rajagopal, Chief Investment Officer, Cholamandalam AMC Limited adds: "It was all to do with the futures and options open interest in the market. The contagion effect of the unwinding in the global markets caused the Indian markets to slide as well. The way it fell was because of the squaring off of existing open interest, which is visible from the fact that the stocks in the F&O segment fell by a wider margin as compared with others."

That apart, the mega IPO of Reliance [Get Quote] Power, besides other IPOs, has led to money in excess of $10 billion (largely institutional money) being locked in as application money.

So, there were many factors including high leverage positions, lesser liquidity, rich valuations, FII selling, excesses in select market segments and rising global concerns among others that led to the steep fall in the domestic markets.

Lessons to learn

One of the obvious learnings for investors is to avoid leveraged positions viz. high exposure in the futures and options segment. Explains Teckchandani, "Avoid leverage. I've been saying that people who do F&O trading have a pathetic future."

Anoop Bhaskar, CIO, UTI Mutual Fund, adds, "Investors have to limit their expectations and cannot think of the markets as a 100-metre sprint. It is a marathon and you have to be patient." In simpler words, look at a longer term of over a year.

The other one deals with risks and rewards. Says Vikas Khemani, Co-Head, institutional equities, Edelweiss Capital, "Markets are driven by greed and fear. Markets rise, greed grows. When reward per unit of risk is high as is the case now, investors do not take risk. Investors are not looking at risk but are focusing only on returns. Risk factor should be borne in mind before investing. In markets like these, it is equally important to remember how much you can lose and not just focus on how much you can make."

Is the worst over?

With the markets down and many investors having lost money, the next obvious question is whether there is more downside from current levels or whether the worst is over. The answer to this one is not easy, considering that a lot of concerns still exist. For one, nobody knows whether the US will eventually manage a soft landing or whether it will experience a recession and the eventual impact on global economic growth. Says UTI's Bhaskar, "With 50 per cent of world output headed towards the US, the world is affected by any slowdown in the US. India cannot be immune."

Says A Balasubramanian, CIO, Birla Sun Life AMC, "Decoupling may work to the extent of economic activity as domestic consumption will remain high in spite of a global economic slowdown. However, from a corporate growth point of view, since industries are globally interconnected, those with higher global interdependence are bound to suffer. Add to this, local investors' sentiment responds more to the global sentiment."

Even assuming that India were to be largely insulated, the global growth slowdown would translate into a decline in global stock markets. Thus, in that sense, as valuations of other markets decline, on a relative basis, India would appear to be expensive -before the market crash, India was amongst the most expensive markets in terms of valuations trading at over 20 times estimated FY09 earnings.

On the positive side, some India-based investment experts seem to believe that the worst may be over and the 15,500 points that the BSE Sensex made on Tuesday, could be deemed as bottom. On the other hand, a few others are still not so sure. That's due to the lack of clarity on the possibility of a US recession and its impact on global economic growth. Domestic factors like interest rates, inflation and 2008-09 Budget among others, will also have some bearing on the market trend. Hence, they believe that these factors will determine the future course of the market.

For long-term investors though, this could be an opportune time to make money. Explains Tridib Pathak, Chief Investment Officer, Lotus India AMC, "I think disciplined investors love the period of pain, because that is the time when you get serious long-term investment opportunities and attractive values." Adds Vikas Khemani, "This is the time to take risk as the long term story is sound and intact. Even if there is short term pain, stick on."

What next?

Assuming that there may still be some downside left, what should investors do now? A fall in the popular indices or share prices across the board may not necessarily mean that things have changed. It's perhaps indicating that the fall has corrected the excesses that existed in various pockets. But, more importantly, what it also signals is that quality growth stocks can now be bought at reasonably fair valuations. Broadly speaking, the price-to-earnings (PE) ratio of the market has fallen from 22 times to 17-18 times estimated FY09 earnings. And, given that corporate earnings are likely to rise between 18-25 per cent a year, over the next two years, the PEG (PE to growth) ratio at under one time provides comfort. A ratio of under one, to an extent and largely applicable to non-commodity stocks, suggests that valuations are not exorbitant.

But before going to the sectors or stocks to invest in, it is important to note that the next three to six months or a bit more could be painful given that some uncertainties still exist. Hence, a long-term perspective of three to five years is most desirable.

Having said that and also considering the macro environment, it's advisable to play safe by investing in companies with exposure to domestic consumption or investment plays. For instance, companies operating in the infrastructure and construction, banking and financial services, retail, telecom, entertainment, capital goods and engineering, and FMCG space, are better placed than sectors like information technology or textile exports, where companies derive a large chunk of their revenues from countries like the US. A firm rupee, uncertainty regarding IT budgets of US-based companies and cost pressures (rising wages) are among the factors that are weighing heavily on domestic IT stocks. The current environment suggests that good days are far from sight.

As a contrarian strategy, investing in companies from the automobile sector can prove to be beneficial and perhaps capable of providing a boost to overall returns. The reasons for the contrarian strategy hinges on the belief that sooner or later, given the rising interest rate differential between interest rates in India and abroad, the benign domestic inflation and subdued crude prices (under $90 a barrel), the RBI may be pushed to lower interest rates. Should that happen, it could lead to better growth for auto companies.

Overall, experts believe that the Indian markets can deliver decent returns ranging 15-20 per cent annually for the next two years. And prudent stock picking can help achieve even better returns.

So, be disciplined, don't over leverage or take higher risks, maintain your asset allocation as per your long-term goals, be patient and be discreet in picking stocks.

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