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India's stocks in overreach mode
By Kunal Kumar Kundu
BANGALORE - India's benchmark stock index, the Sensex, posted a return of close
to 67% in the nine months to the end of September, the highest among leading
global indices. It even beat out China, which has started to retrace, owing to
overheating concerns.
The rise of the Sensex, which has more than doubled since reaching a low on
March 9, has not been backed by any substantial improvement in corporate
performance. This is evident from the fact that the price-to-earnings multiple
has been rising steadily, recording one of the steepest rises since 1991 - and
credit for that gain in the early 1990s should go to stock broker and
manipulator Harshad Mehta [1] rather than real economic performance.
In the above chart, the different factors that have led to the overheating of
the Indian stock market since the 1990s are highlighted.
The spike in the stock market in 2007 can be mainly attributable to the large
flow of liquidity, driven by foreign institutional investors (FIIs). With India
averaging 9% growth in gross domestic product (GDP), the lure of the stock
market was too hard to resist. As liquidity continued to be pumped into the
market, the stock markets soon ran ahead of fundamentals. This coincided with
the financial crisis that originated in the United States but soon engulfed the
world. Just as the money arrived in droves, it went out at an even faster pace
as panic started to spread and the market tanked by about 60%. As inflation
inched up and growth slowed, pessimism ruled the market.
Sentiment, however, was reversed when it was realized that despite a slowdown,
India was still in a much better relative shape when the developed world went
into a recession and the developing economies in East Europe were simply
vanquished, with a handful of them being forced to approach the International
Monetary Fund for bailouts.
India, like China, stood out in the midst of severe devastation all around.
Then out came the results this past May of India's general election. The mere
fact that the left parties (whose obstructionist attitude had most of the time
acted as a thorn in the government side) had been routed was perceived as
reason enough to believe that all necessary reforms would see the light of day
and India would revert to 9%-plus growth, sooner rather than later.
Added to this was the stimulus provided to the economy by the new government,
as deficit concerns took a back seat.
As sentiment improved, liquidity began to move in, again more specifically from
FIIs.
In the first two quarters of this financial year, total FII inflows crossed
US$35 billion, with the majority of them taking place post the election. There
is no gainsaying the fact that FII inflows have had a big impact on market
valuation.
However, their influence increased substantially from 2007 as a global glut of
liquidity led to a deluge. Not surprisingly, while the simple correlation
coefficient ("r") between FII inflow and the Sensex has been 0.215 from January
2000 to the present, the "r" value increased to 0.675 from January 2007 onward.
Clearly, the market is now much more susceptible to the vagaries of FII flows.
While the 2007 deluge was followed by substantial pullback following the
crisis, the recent liquidity injection by governments as part of their stimulus
packages has resulted in liquidity rushing to equities as an asset class all
over the world, and India is no exception.
In September, net FII inflows surpassed the US$10 billion mark. Not
surprisingly, the rupee appreciated by about 4.5% in one month.
Another channel for foreign cash to enter the market is through the
Participatory Note, or P Note, route. For the uninitiated, P Notes are
instruments used by investors or hedge funds that are not registered with the
Securities & Exchange Board of India to invest in Indian securities.
India-based brokerages buy India-based securities then issue P Notes to foreign
investors. These are thus instruments that are used for making investments in
the stock market but are not actually used within the country.
Inflows though this route have also been quite substantial and have been
steadily increasing, nearly doubling this year to 1.1 trillion rupees (US$24
billion) from 658 billion rupees. Clearly, this is hot money, highly
susceptible to sentiments and herd mentality.
The surfeit of liquidity is not entirely of foreign origin. There's also ample
liquidity in the domestic market, helped by loose monetary policy. This is
exemplified by deposits growing at a faster pace while credit growth remains
muted. In fact, non-food credit growth has been on a declining trend since
October 2008, and only in July was there some hint of reversal.
Not surprisingly, the credit-to-deposit ratio (CDR) has been in decline.
And, despite a pick-up in non-food credit growth in July, the CDR was down by
80 basis points, indicating a much faster growth in deposits. Clearly, credit
flow into the real economy fails to give the confidence of a higher GDP growth
that the market is expecting. I have, on a couple of occasions earlier
enumerated my concern why GDP growth this financial year will be below 6%, and
nothing much has changed to warrant optimism. (See
Indian economy drier than forecast , Asia Times Online, September 4,
2009).
On the other hand, monsoon worries have been justified. For the monsoon period
June 1 to September 30, India experienced a deficient rainfall of 23%, a
three-and-half-decade low - it was in 1972 that the rainfall was deficient by
24%.
The problem does not end there. The southern states received heavy rainfall
toward the end of the monsoon period, and as a result they ended up being the
least deficient region (at 4%). But rather than the rainfall being spread
across the period, it was very heavy toward the end, resulting in widespread
floods after a spell of drought. The states of Andhra Pradesh and Karnataka
have been the worst affected. This has resulted in a tremendous amount of crop
loss.
Initial estimates coming in from Andhra Pradesh pegged the estimated loss at 2
billion rupees, and this may increase. The situation in Karnataka is hardly
different. The available information suggests the entire rabi crop, or
spring harvest, has been completely ruined and over 70% of the kharif,
or autumn, crop has been lost because of prolonged drought and then
waterlogging for three to four days during the floods.
Despite the highly optimistic prediction of government officials, this year's
GDP growth could struggle to cross 5.8%, the level I am expecting.
The stock market seems to be far more optimistic on the prospects for growth.
Earnings growth of even 20%-plus will not be sufficient to justify a
price-earnings ratio of 20. Hence the expectations seem to be unrealistic.
Last quarter's good corporate performance had a lot to do with stringent
cost-control measures undertaken by companies and increased focus on reducing
leverage.The top line, or revenues, hardly grew. Nor is there any indication
that there will be a dramatic improvement in the top line in the next two to
three quarters. Margin growth through pure cost-control measures is not
sustainable. Sustenance requires consistent top-line growth, which does not
seem possible in the short to medium term.
At present, therefore, the market valuation seems to be quite stretched and
corrections are expected. In the long run, nevertheless, India's growth story
remains intact, despite constraints such as weak governance and the inability
of New Delhi to carry forward meaningful reforms. Improvement on those fronts
will perk up the growth rates even higher. In the longer run, Indian equity
markets remain well placed. Caution is advised in the short run.
Note
1. Harshad Mehta was eventually charged with 72 criminal offenses for his fund
and share-dealing practices, and more than 600 civil action suits were filed
against him. He died in 2002 with many cases still pending against him.
Kunal Kumar Kundu is Principal Consultant, Financial Research Knowledge
Service, Infosys Technologies Ltd. The views expressed are those of the author.
(Copyright 2009 Asia Times Online (Holdings) Ltd. All rights reserved. Please
contact us about
sales, syndication and
republishing.)
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