What’s melting the market...

The latest corrective phase has many macro-economic facets — surging crude and commodity prices, double-digit inflation, rising interest rates and political uncertainties — that threaten to curb fund flows to India and pose a risk to earnings.

For investors who have survived various stock market corrections in India over the past four years, the recent one must have come as something of a shocker. With a 40 per cent slide from peak to trough, this meltdown has been sharper and more prolonged than any other corrective phase witnessed since the bull rally took off in 2003.

So what’s different this time? What, for instance, sets apart this market fall from the 30 per cent correction in 2006? Here’s a look at the patterns and trends in the recent market slide, and the fundamental and technical factors at play.

Challenging macro scenario

The recent corrective phase has many macro-economic facets to it — both global and local — several factors pose a potent threat to company earnings and fund flows into India.

While concerns arising from the US sub-prime crisis and the ensuing credit crunch threaten to curb fund flows to India, surging crude and commodity prices, double-digit inflation, rising interest rates and political uncertainty now pose a risk to earnings.

None of the earlier corrections saw the coming together of so many negative factors. In the August 2007 correction, limited to a 10 per cent fall, the factors at play were mainly global (sub-prime crisis). The 15 per cent correction in March 2007 was primarily caused by the Chinese market meltdown and the subsequent backlash of the yen carry trade. On both these occasions, the market slides were limited to under a month, by which time both the broad markets and FII investments had begun trending up.

The deeper correction in May 2006 shaved over 30 per cent off the Sensex’s peak value and was driven mainly by fund flows, rather than by fundamental factors. A 0.25 percentage point interest rate hike by the US Fed, with promise of more to come, prompted FIIs to reallocate their funds from ‘risky’ emerging markets to the stable developed markets. Interest rate fears also triggered a global sell-off in the commodity markets, leading global investors to book profits on metal stocks in emerging markets too.

This contrasts with the current scenario where global investors have chosen to divert their investments to commodities. So, while the correction of 2006 was driven by falling commodity prices (which are good for corporate earnings); this one is driven by rising commodity prices, which actually pose a threat to corporate earnings.

While the government has taken policy measures to rein in price inflation, the rise in commodity prices is a global phenomenon, triggered by tight supplies. Optimists can take comfort from the fact that in recent times, the indicators of industrial production in both India and China have begun showing signs of moderation; lower demand may ease demand pressure on commodities, while an unwinding of speculative positions may also trigger a correction.

Earnings slowdown

The fundamentals of India Inc today appear shakier than they were in 2006. There are signs from the recent IIP numbers that rising interest rates are taking a toll on industrial production; sales of automobiles and consumer durables have wound down on the back of dearer credit. In 2006, corporate India’s growth juggernaut was just beginning to gain speed; Indian companies notched up a 23 per cent growth in sales and 25 per cent growth in profits in 2005-06.

In contrast, India Inc’s earnings actually slowed in FY08, hit by higher oil and metal prices and rising interest rates. In FY08, companies recorded overall growth of 19 per cent in sales and 25 per cent in profits, lower than the 27 per cent sales growth and 41 per cent profit growth in FY07.

This growing consensus about a slowdown is corroborated by the recent downgrades in earnings estimates for Indian companies. But the question now is the extent of the slowdown. The prognosis for the market will depend on whether the current economic slowdown is merely “cyclical” or likely to prolong. Corporate earnings for the June quarter will be keenly watched and so will IIP numbers for the coming months.

Weakening rupee

The rupee was also a factor in the recent market correction. With stock prices already retreating, the depreciating rupee further trimmed dollar returns for FIIs. The year-to-date Sensex return, a negative 35 per cent, is a good 6 percentage points worse in dollar terms. Some of the FIIs’ new-found dislike for emerging markets may also be attributed to the unexpected appreciation of the dollar against most Asian currencies in recent months.

The outlook for the rupee, which is pegged partly to the capital inflows situation, currently looks weak given the widening trade deficit arising from an expanding oil import bill. With the European Central Bank recently hiking the benchmark lending rate by a quarter point to 4.25 per cent (seven-year high) and the Federal Reserve likely to follow suit, investing in Indian equities may become that much more uninviting.

Foreigners flee

While every major corrective phase in India over the past four years has been triggered by FII selling, this one stands out for the quantum of outflows and the prolonged FII apathy. If the stock indices fell by 30 per cent in May 2006 after FIIs pulled out Rs 1,630 crore, in January 2008 alone they took almost double that amount off the table.

So far, the FIIs have sold over Rs 6,312 crore in 2008. Besides, in the six months that followed the January sell-off, FIIs figured as net buyers in only two months (February and April), alternating their purchases with selling the very next month.

An interesting sidelight is that domestic mutual funds were aggressive buyers on both occasions in the first month of correction — both in May 2006 and Jan 2008. This time around, even the retail investors appear to have been bullish in the early part of the correction.

There is as yet no sign of redemption pressure on domestic mutual funds. With equity fund managers sitting on higher cash positions (10-20 per cent) and reasonable ULIP collections, domestic institutions can step in if the valuations appear attractive. But they may not have the wherewithal to compensate for any concerted withdrawal by FIIs.

Sweeping correction, but defensives escape

The recent fall, unlike its predecessors in 2007, 2006 or even 2004, has been more widespread and deep, in terms of individual stocks.

The 2008 correction may have caused more damage to retail portfolios. Sample this: In May 2006, just 17 out of 100 stocks fell more than 50 per cent, while 63 out of 100 fell 30-50 per cent. Now, over 53 per cent of the stocks have been reduced to half their values from their January highs and 31 per cent of the stocks have shed 30-50 per cent (till June 27th).

However, the recent correction has been more discriminating and sector-specific.

Sectors such as IT, FMCG and pharma, with defensive connotations, bucked the broad market fall to a large extent. The fact that these sectors were under-owned by FIIs may also explain this trend.

The previous three corrections left Indian market’s valuations at a big premium to the other emerging markets. Not so in 2008. Six months of ruthless selling in equities has led to a sharp drop in the price earnings multiple of the Sensex, almost levelling it with other emerging markets.

From a peak of over 28 times its earnings, the Sensex basket now trades at a modest valuation of over 16 (13 times forward earnings). Even though this is at a premium to some Asian peers such as Hong Kong (12.8 times), Singapore (10.72 times) and Taiwan (12.7 times), the valuation gap has narrowed significantly from its January highs.

Current valuations have also plunged below the five-year average of 18 times. With the recent meltdown dissolving the speculative froth, investors entering the market now may be at lower risk of a steep valuation ‘de-rating.’

Outlook

There’s been no dearth of negative news in recent months, keeping retail investors in a state of trepidation. But here are a few positives that suggest India may still be a fertile ground for long-term investments.

Net foreign direct investments into Indian companies have grown by over 82 per cent to $15.5 billion in 2007-08. A global survey of corporate investment plans by KPMG has forecast that India will see the largest growth in its share of foreign direct investment, becoming the world leader for investment in manufacturing in five years.

Private equity M&A targeted towards India has grown to $ 2.1 billion (52 deals) till April 2008, compared to $893 million in the year-ago period, according to Dealogic.

Interestingly, the report states in the same period, there has been a fall in the private equity investments in developed nations such as the US, the UK, Japan and Germany.

Buyback announcements from companies such as DLF, Reliance Infrastructure, Great Offshore and JB Pharmaceuticals are signals that companies consider their stocks undervalued. “Insider buys’ by the promoters of companies such as Marico, IDFC and PVR are also positive signals of promoter sentiment.

Large Indian companies have carried out a string of acquisitions (Spice-Idea, Ranbaxy stake sale, Tata Motors-Jaguar) in the recent past which could deliver disproportionate growth over the long-term.