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The Yo-Yo Effect

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All of Delhi was beginning to feel the chill of winter last fortnight, but in a room at the Oberoi Hotel, a heated discussion between investment bankers, economists, some CEOs and heads of three or four Chilean pension funds, revolving around India's growth potential and that of its stockmarket was underway. Latin American pension funds manage $150-200  billion in assets, so them being interested in India seems understandable.

"We have had expressions of interest from Canada, even Denmark," says a surprised Kaushal Aggarwal, managing director at Avendus Capital, a Mumbai-based financial services firm. "In the past few months, pension funds with $10-20 billion in investible funds have been making enquiries, looking to invest $300-400 million in Indian stocks."

Cut to Mumbai and Avinash Gorakshakar, head of research at Anagram Stockbroking. Since the stockmarket began to fall from 5 November, Gorakshakar has invested 35 per cent of his money in just three stocks: Elecon Engineering, BGR Energy and BS Transcomm. "The correction actually has been a boon in disguise," he says.  "Capital goods stocks may have been laggards, but going ahead, I see huge value in this space, and I am buying with an investment horizon of 10-12 months." He was sitting on 60 per cent cash before the fall.

 Foreign funds and marketmen have both been enthusiastic from when the benchmark Bombay Stock Exchange (BSE) Sensex kissed the 21000-mark for the first time after three years (when the Sensex had touched its all-time high of 21206.77 on 10 January 2008). If there is such intense interest from a wide variety of investors, then what explains the surprising 10 per cent tumble in the market?

The Confluence Of Circumstances
"This is a correction, not a reversal," says Rashesh Shah, chairman and CEO of Edelweiss Capital, a leading Mumbai-based financial services firm. "In any bull market, the possibility of a 10 per cent correction is always built in. A set of expectations on the basis of which positions were taken, have been belied, both domestically and internationally. This is a reflection of those failed expectations."

Shah underscores three of these. First, the expectation that the US Federal Reserve's second round of quantitative easing, or QE2, would result in a rush of capital flows, didn't come to fruition. Instead of depreciating, the US dollar appreciated, not just against the rupee, but also against the Japanese yen and the Euro.

Second, India's economy displays characteristics that are in stark contrast to the rest of the world — high interest rates, high inflation and tight liquidity. That increases risk aversion.

Third, since equities are riskier, investors are moving into bonds, which offer both a good yield and greater safety. "When the yield curve is steep — low interest rates at the short end and high at the long — most investors move into long-term bonds," says Shah. State Bank of India's bond issue, for instance, at 9.5 per cent, was oversubscribed heavily. ICICI Bank's Eurodollar bond issue got a similar response.

Click here to view enlarged imageThere is one more and simple explanation: profit booking by foreign institutional investors (FIIs), with an eye on showing the kind of performance that merits a nice bonus. Almost mimicking the FIIs, portfolio managers in India, too, have similarly booked profits. "We did well so far this year," says Vivek Mavani, vice-president of portfolio management services at Brics Securities in Mumbai. "We took some of the profits off the table, and built a cash position — about 25 per cent — for picking some new winners."

Marking Time
Mavani is not alone. "Foreign fund managers have generated positive returns, even double digit-returns, in India," says Gurunath Mudlapur, managing director at Atherstone Capital Markets. "Also, a 20 per cent rise (in the market) in less than two months is huge; so capitalising on it and booking profits is only natural."

"Usually, when markets are perceived to be overvalued and supported by liquidity more than anything else, any excuse is good enough to sell some part of your position," explains a dealer in an FII brokerage house on condition of anonymity (see ‘When Performance Counts').

While FIIs may be booking profits, will foreign capital continue to flow in? "Renewed fears about the European sovereign debt situation have clearly impacted risk appetite globally, and that has affected Indian equities along with other emerging markets," says Ashish Gupta, head of research at Credit Suisse.

Agrees K.R. Bharat, managing director at Advent Advisory, when he says, "After all, ours is a global liquidity-driven market. Foreign inflows have been a major factor in driving the Indian market higher, but when risk appetite is affected by events outside India (like the current tension in the Korean peninsula), the withdrawal of some of this liquidity will impact us."

Then, there is the small resurgence in the US economy. US unemployment, though still high at over 9 per cent, is witnessing some moderation; unemployment insurance claims dropped to their lowest level since July 2008, and the trade deficit narrowed marginally in September to $44 billion from $46.5 billion in August, helped no doubt by the dollar's appreciation. And General Motors made a public offer of shares to raise capital that received a tremendous response.

While Coal India's initial public offering (IPO) is one for the history books, will Indian retail investors show the same degree of interest in upcoming IPOs as well?

Wherefore Art Thou, DIIs?
Domestic institutional investors (DIIs) such as insurance companies and mutual funds have stepped in every time FIIs have sold in past corrections. But this time, they are conspicuous by their absence. Two reasons suggest themselves as proximate causes; one, regulatory restrictions on incentivising the sale of their products — both insurance and mutual funds have to be sold, rather than bought like bank deposits — have impaired their ability to raise money for investing in the stockmarket. Two, retail investors somehow have stayed away from these institutions after being burnt by experience following the global credit crisis of 2008.

Click here to view enlarged imageRather than incremental inflows, redemptions and repurchases have dogged DII fortunes. Other than churning of the assets under management, DIIs as a source that could offset FII outflows, have had negligible impact. In the past year, the stockmarket has not received any support by domestic institutions; rather, in the year till October 2010, investors have taken over Rs 17,000 crore out of these institutions (see ‘Moving In Tandem', page 35).

High net-worth individuals (HNIs) have been another reliable set of investors who took opportunities and bets during corrections. But in this latest one, they, too, have preferred to stay away. If anything, they have gone the profit-booking route, like other large investors.

But most market analysts shrug off the seeming absence of support for the market as only natural. "All domestic factors — the monsoon, GDP growth, etc., — that drive the market, have effectively been played out," says Mavani of Brics Securities. "Besides, this has been a fast  rally. At the end of May, the Sensex was around 15600; at Diwali (early November) it crossed 21000. There has been no serious correction in all this time. So this was, in a sense, overdue."

One strategy would be to see the stockmarket in pieces. "Indian equity markets will now have to be viewed across segments," says Satish Ramanathan, director and head of equity at Sundaram Mutual Fund. "There is vibrancy in the mid-end of the market with a number of smaller cap stocks hitting new highs, while the large-cap stocks are currently in a phase of consolidation, as valuations are rich and growth expectations are fully factored in."

 Mavani adds that all the FIIs have done is take profits off the table; the principal is still invested. But the questions persist.

The last time the Sensex touched 21000 in early 2008, it marked the end of that bull-run.  Does the latest fall from its all-time closing high of 21004.96 on 5 November, seem to give a similar indication? On 26 November, the Sensex ended at 19136.61, roughly 9 per cent down, and within the scope of a correction.

Despite this sharp correction, the BSE Sensex is still up by 10 per cent in the year so far. "In the past two years, it has been a one-way movement," says Nilesh Shah, managing director and CEO of Envision Capital, a Mumbai-based financial services firm. "History suggests that the Sensex has corrected every two years, so a sharp fall can't be ruled out. Now that the correction is underway, the Sensex could fall to 17000."

The Stench Of Scandal
Political scandals stemming from the corruption around the grant of telecom licences may seem far from the stockmarket's daily strife, but they have had some effect. The latest scandal involving LIC Housing Finance — essentially about bribing highly placed-officials for sanctioning loans to real estate and construction companies — has dampened sentiment somewhat.

Bank stocks have fallen steeply, many by more than 10 per cent, including SBI and Axis Bank, and now LIC Housing Finance. Often, in a correction like this one, many stocks correct by over 20 per cent. For the past couple of months, banking stocks have displayed a greater degree of volatility than any other sector.

But again, many market analysts argue in the context of the LIC Housing Finance scandal, that this sort of wheeling-dealing has been around for a long time. "We don't condone it by any stretch of imagination, but it is hardly the sort of event that will crash the market," says the head of research at a leading securities firm, rather cynically.

While the scandals have affected sentiment, some market players worry about a larger undercurrent: if the probe into former telecom minister A. Raja's decisions throws up unpleasant results, which lead to cancellation of already issued-licences (the Telecom Regulatory Authority of India, or Trai, has belatedly recommended the cancellation of 69 licences), it will be a whole new ballgame. The stability of policy and policymaking will be up for question, and could spread through the economy and the markets. "A joint Parliamentary committee (JPC) may be bad for markets," says one concerned analyst.

Unintended Consequences
But there is another seemingly strange development in another part of the market. On 25 November, the unofficial premium for the shares of Manganese Ore India, a public sector undertaking whose IPO opened on 26 November, was Rs 250 over the issue price suggesting a listing at Rs 600 a share. On the day the issue opened, the premium came down to Rs 175. But this is a good indication that hope still resides in the primary market: the success of Coal India has been a powerful marketing tool.

Ironically, the success of upcoming PSU IPOs could do more than just improve the government's fiscal position; it could revive retail investor faith in the market. Many retail investors have been sitting on the refunds they received after Coal India shares were allotted — it is a large corpus of a few thousand crores.

The government, on its part, is readying to take advantage of the retail interest in PSU IPOs: nearly Rs 53,000 crore from stake sales in Indian Oil Corp (Rs 20,000 crore), SAIL (Rs 18,000 crore) and ONGC (Rs 15,000 crore). In the Coal India IPO, the stock opened at a 20 per cent premium to its offer price. The realistic pricing strategy of the government appears to have worked.
But will that retail investor faith extend to the secondary market? "They [investors] are still feeling the effects of the post-2008 meltdown," says Edelweiss Capital's Shah. "They are still carrying the scars." Apart from IPOs that promise value, retail investors are placing their bets on bonds and in some other debt instruments.

But that's not necessarily the end of the world: some analysts believe that the retail segment is waiting for the right sense of value. "There is a strong buffer built into the market," says Aggarwal of Avendus Capital. "Investors are waiting for the correction to play out, and to step in and support the market at lower levels. It is fairly certain that the market may not drop below 18000." Perhaps. But what else could support the market's rebound?

Prospects For Clear Weather?

What worries many is the inflation overhang that casts a long shadow on everything from food prices to real interest rates. "There has always been a high correlation between interest rates and the stockmarket," says Shah. "Investors tend to look for better yields in riskier assets when interest rates are low. The stockmarket began to boom in 1995-96, when interest rates started to fall to lower levels from the 15 per cent prevalent till then."

The converse is also true: when interest rates rise, risk aversion sets in. "Inflation remains a key downside risk for domestic growth," says K.N. Sivasubramanian, CIO (Franklin Equity-India) of Franklin Templeton Investments. "Any reduction in risk appetite could dent capital inflows and add to policy challenges on the balance of payments front."

Volatility and uncertainty will persist well into the last quarter of the financial year. Earnings estimates for the third quarter of FY11 are not very bullish, but better for the fourth quarter, an important factor for institutional and large investors. The picture on the government's fiscal position will also become clearer then. Hopefully, the string of successful IPOs will relieve the fiscal deficit stress and cheer markets.

The mists over Delhi — real and metaphorical — will clear up just before the government budget is presented in February 2011. In January and February, there have almost always been pre-budget market rallies. Temper that expectation with the knowledge that after seven out of every 10 budgets, markets have always fallen as expectations are belied in some fashion or other. That is what this market has been all about: expectations, great and small, belied and realised.