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BW Businessworld

Riding The See-Saw

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Two weeks ago, Pankaj Vaish was not unduly worried about the direction of the stockmarket. Like many of his contemporaries, this managing director and head of equities and fixed income liquid markets, India, at Nomura Securities in Mumbai, thought that market indices could perhaps burst through on the upside, based on fund flows. But now, he is less certain about what to expect.

The 20 per cent-plus fall in the Chinese stockmarkets in Shanghai and Shenzen in just over two weeks - seen as a response to the tightening in Chinese credit markets - is giving most market participants and observers a pause. On Monday, 30 August, the Shanghai Composite Index fell 6.7 per cent. And the fall in Indian stockmarkets over the past week has fuelled a debate about how much Indian markets respond to Chinese cues.

The recent raft of numbers - on GDP, trade and first quarter earnings - looked decent enough to warrant the climb in the Bombay Stock Exchange's Sensitive Index (Sensex). But the fall in Chinese markets has everybody questioning stock prices again. "It has been a manic, depressive market over the past six months," says Vaish, referring to the swings. "Overall, valuations are fair, but could border on the worrisome if the Reserve Bank of India (RBI) is forced to tighten monetary policy in 2009."

The current skittishness about the direction of the markets appears to spike from time to time, but many see it as an undercurrent that has been present for a while now, both in India and in other emerging and developed markets. True, economies around the globe are showing signs of stabilisation, but corporate profits as a percentage of GDP have not reached the 'pre-Lehman' levels, or those prevailing before the collapse of the investment bank Lehman Brothers in the second half of 2008.

Click here to view enlarged image (Graphic: Neeraj Tiwari)Two of the three factors that drive market movements - sentiment or investor confidence and liquidity - have both improved vastly since March of this year. No one expects the third factor - earnings - to bounce back that quickly, given the global recession. The weaker-than-expected pace of the recovery, however, is causing varying degrees of alarm.

What is a little more worrying is the volatility that accompanies uncertainty. Take prospective Sensex earnings per share (EPS) for instance: estimates of this number range from a cautious Rs 900 to over Rs 1,100 for FY10, an aggressive estimate. And even in some global markets, the numbers seem out of sync with reality and with no justification or foundation to actuals. So will the market recovery look V-shaped, W-shaped or like the new metaphor: shaped like the square root symbol? Or will there be another sharp fall before things get better, as some are worried about?

How Does Your Recovery Grow?
"Crashes don't occur when people are worried about them," says Rashesh Shah, chairman and CEO of Edelweiss Capital, a securities firm. "What happened in 2008, for instance, was completely unexpected." Three things, he says, have changed since December: liquidity is easier, the fear of a global depression has vanished, and commodity prices - always a key factor - have firmed up. And consequently, asset prices have firmed up.

Most global markets are now talking about a U-shaped recovery. The US markets are expected to stabilise in the first quarter of 2010 - consumer confidence has fallen back to 63 per cent from 68 per cent, and unemployment remains high. Without the US consumer, it is hard to see any sustained recovery in the global economy. The other worrying factor is the other side of the equation, namely China.

Some proponents of the crash theory suggest that market movements - and capital flows - the world over are being driven by currency views and perspectives. The story goes something like this: as the pace of global recovery has been weaker than anticipated, most investors are withdrawing into zones of safety, such as the US markets. The dollar has been weakening considerably, they say, because all that central bank-induced liquidity has created a dollar carry trade to replace the Japanese yen carry trade.

As the dollar weakens, dollar-denominated equities get stronger. So in the next few weeks and months, more money will flow into US markets while global fund managers pause to take a fresh look at the global recovery, or the lack of it. "We expect developed-market equities to surprise on the upside, perhaps even by 20-25 per cent," says Biju Samuel, an analyst with Quant Capital in Mumbai. "Emerging markets - particularly the BRICs (Brazil, Russia, India and China) - have returned to their pre-Lehman levels, but developed ones are still below their pre-Lehman days."

So what will happen to capital flows in the next few weeks? Look at the differential between the US Federal Funds rate - the rate at which the US Federal Reserve lends to banks and other financial institutions - and the 10-year Treasury note for indications. If the differential falls to less than 2.5 per cent, money flows into emerging markets, including India. If it goes above 3 per cent, money goes into the US markets. Last week, some $300 million flowed into Indian bourses.

Home Bias
At its peak, global market capitalisation was around $75 trillion before it fell to about $35 trillion. Since then, about $20 trillion of that value has been recovered, taking the current world market capitalisation to $55 trillion or thereabouts. In India, out of about $12 billion in capital outflows in 2008, $11 billon has come back. But the Sensex, which was then 21000, has recovered to only around 15500. It seems there has been less bang for the buck.

Most market participants and observers maintain that India's growth - and stockmarkets - will be a function of domestic rather than global conditions. "The Indian market is more broad-based than it ever was, and that implies new businesses are being developed," says Motilal Oswal, chairman of his eponymous company, Motilal Oswal Securities. "The concerns about the monsoon have ameliorated  somewhat, and economic conditions, as reflected in the GDP and trade data releases, look comfortable," says Oswal.

THE NEW GEOMETRY:? W Y Among the various recovery shapes, the ‘square root' scenario is the latest metaphor for the global market recovery (offered by Merrill Lynch) — the economy bottoms out, bounces back about halfway to the previous peak, and levels off for a while

That Indian business is getting more diverse - as are the stocks listed on the market - is hard to argue with. In 2000, the information technology (IT) sector accounted for 33 per cent of the market cap of the broadest index, the BSE 500. Oil and gas accounted for 18 per cent, and banking and financial services for roughly 15 per cent. Real estate and utilities were not even specks. Today, IT accounts for just 8 per cent, but utilities are 8 per cent, real estate about 2.6 per cent, and metals over 10 per cent of the BSE 500 market cap.

Some analysts go so far as to point out that had it not been for the global credit crisis, it is conceivable that companies currently in the doldrums, such as Subhiksha, Great Offshore or Wockhardt may not have been in the trouble they got into. "Vijay Sheth of Great Offshore had to sell his stake at Rs 130 a share, which is now worth Rs 550 to the owners of Bharti Shipyard," says an analyst, who did not wish to be named. "They just blinked then. Asset prices are back now." The underlying strengths of the Indian economy, he suggests, are still in place.

Stable Economy, But Weak Stockmarket?
Others are less sanguine. If the market has to have a clear upward trend, the overall economy needs a booster shot. And that can only come from increased consumer confidence. "Consumption is still the key to demand generation and thus profitability growth," says Murali Krishnan, director of research at Ambit Capital. "There may be growing consumption in automobiles, for instance, but there is also significant down-trading, and perhaps even a postponement of consumption."

Figures in $ million; RHS: right hand side; LHS: left hand side; MSCI India: Morgan Stanley Capital International India Index; FII: foreign institutional Investors; EPFR: Emerging Portfolio Fund Research Source: EPFR, Quant Broking (Graphics By Saurabh Deb)Click here to view enlarged imageTrue, the less-than-satisfactory monsoon and the concerns over consumer price inflation are causes of worry creases. The prevailing consensus view is that things are getting better. "If you look back to March this year, we saw bad credit markets, a gigantic inventory liquidation, immense liquidity infusion by central banks and government stimulus packages," says Sandeep Kothari, fund manager at Fidelity Mutual Fund in Mumbai. "Now, credit markets are working again, and confidence has returned. This is a classic business cycle kind of movement."

Then why the investor uncertainty? "It's a case of whether you see the glass as being half full or half empty," says Nilesh Shah, deputy managing director at ICICI Prudential Asset Management. "We are like athletes coming off steroids; the after effects have to be dealt with." Shah points out that all categories of players - foreign institutional investors (FIIs), domestic financial institutions including mutual funds and individual investors - are all in, even if the markets are in limbo.

From an assessment of a wide range of views, this much seems clear: the complex interplay of a number of factors from global shifts to government policy measures has most people guessing. The variation across those guesses has been evident from the rapid revisions to growth and earnings forecasts on the one hand, and from the difference in emphasis that is laid on the driving factors of sentiment, liquidity and earnings on the other.

Sentiment is good; liquidity is comfortable but signs of worry about how long it will be sustained are beginning to appear. The RBI here and other central banks elsewhere have made references to the possibility of tightening liquidity, or that we should at least begin preparing for it. Earnings are also being upgraded. "The question is are earnings going to meet expectations?" asks Kothari. "The inventory rebuilding cycle will go on for a couple of months more; market movements may not be as sharp anymore, but more graduated."

The Outlook: Risking It
On both global and domestic fronts, the market is looking at the risks of riding the bull or running with the bear. Foremost among them is inflation; the second is fiscal profligacy, which even if for the right reasons - for a bad monsoon or a drought, for instance - could get worse. The problem with both is the potential for interest rate increases that could hit company balance sheets hard.

Interest rate increase can make borrowing costs for companies prohibitive, given all the other input costs such as raw material, mostly commodities. Balance sheets could end up full of red ink, and that means lower valuations and falling stock prices. Equity issuances as an option depend on good secondary market conditions. After the success of qualified institutional placements in recent months, several companies made plans to raise equity capital.

"The IPO market has a fairly big pipeline, but that could evaporate if the market tightens and things go back in reverse," says Vaish. "Look at the post-market performance of Adani Power and NHPC, for instance, both of which listed close to issue price or at a very small premium. It was much worse than was hoped for."

The performance of Adani Power and NHPC highlight the problem of pricing an IPO; implicit therein is acknowledgement that valuations may still be stretched, helped by the abundance of liquidity. Besides, people who were left out of the initial rally and are coming in now, albeit cautiously, are keeping valuations at present levels. But many do expect corrections in equity offering prices, at least.


 Some numbers out of China are startling. For example, it took just under three weeks in August for the Shanghai and Shenzen markets to lose 25 per cent in value, something it took over three months to build. Again, there has been more Chinese real estate sold in the first seven months of 2009 than was sold in all of 2007, which was the boom year globally. Chinese loans are in excess of $1 trillion or India's GDP. Money supply is growing at 20 per cent over GDP growth. Will this create another bubble?

Or take the US markets as another instance. On 31 August, of the 1.49 billion shares traded in the first hour on the New York Stock Exchange (NYSE), 606 million shares were in ‘used dogfood' stocks; in other words, crap. And, though Lehman Brothers is not traded on the NYSE itself, 41.5 million shares of the firm, a technically bankrupt firm were also traded in that first hour, leading one commentator to wonder whether the US markets were ‘levitating on trash'.

In Singapore, analysts say that ‘penny stocks' — those cheap stocks that struggle with poor operating cash flows and refinancing troubles — have become the focus of speculators after blue chips have not been able to move beyond the highs they achieved in July. All this is raising a red flag: is there another crash on the horizon?

The third risk is of course, global markets. What happens in China and the US creates tremors in Indian markets; the only question is whether the tremor becomes an earthquake that will lead to another round of capital outflows. So far, however, the risk of that is not so immediate. Most large broking houses we spoke to say that their clients have talked of money flowing into new India-specific funds, including hedge funds in particular.

Against that backdrop, investors are watching three or four indicators as drivers of market direction for the next six to 12 months. First of all, will GDP be at least 6 per cent? Second, how will liquidity behave in developed country markets? Third, how will commodity prices behave? Very clear, but despite all that, markets are irrational, both in exuberance and depression.

Behavioural Finance
Are bulls and bears going through an identity crisis? "Most bears are now more positive, but are reluctant to change their opinion," says Jay Prakash Sinha, senior analyst at Quant Capital. "The same could be true of bulls feeling a little bearish." What is also true is that the wide divergence of positions indicates selective interpretation of the same data.

Resistance to behaviour change is evident in other ways too. Despite the overwhelming trading volumes and buying and selling on the National Stock Exchange (NSE) compared to BSE, and which also has an index - the Nifty Fifty - the Sensex continues to be the benchmark index. It has just become a habit that is hard to break. The reluctance to change habits or positions is not restricted to just domestic market participants either. "If you look at foreign investors, strategists may overweight India, but it's not clear that fund managers follow the same process," says ICICI Prudential's Shah. "People always seem to be waiting for some kind of trigger."

Greed and fear are often cited as the dominant emotions in the stockmarket. Neither seems to explain the skittishness and nervousness currently prevalent in the market to a satisfactory degree. "Perhaps it may be the greed builds slowly, and grows over times," says one broker. "The impact of fear is sharper, a little more extreme."

But neither does that explain why the stockmarket went up by over 10 per cent within the first minute of trading in May, the day after the national elections; the market had to be closed for the day after that rise, when the 'circuit-breaker' was triggered. What is even harder to explain is why the market stayed at that level since, and has risen even further since then.

Perhaps the only thing that can capture the confusion within the market is the title of a Mel Brooks film that itself is a parody of an earlier Alfred Hitchcock classic Vertigo that starred Jimmy Stewart and Kim Novak: High Anxiety.