There are no easy answers. For the time being, investors have been carried away by sentiments, thus overruling the fair domestic fundamentals, prompting some market players to advice caution to clients before taking any fresh position.
According to Balakrishnan Kunnambath , MD, global market manager, SG Private Banking (Asia Pacific): The Sensex currently trades at valuations of 19.2x FY08E and 16.3x FY09E. These valuations are at the upper end of the band, especially given the slow down possibility that clearly calls for a caution at these levels. Our house view continues to remain cautious on the overall market as the valuations are in the expensive zone and growth is tapering off. However, strong liquidity will continue to chase risky assets and drive valuations beyond fundamental fair valuations.
As long as liquidity flows continue unabated, mainly from FIIs, the sky is the limit for domestic equity indices. But then, the fund flow will depend on how much these global institutions have diversified to various risky asset classes and complex structured financial products across the globe. Till now, with the emerging equity class being more profitable, it is easy for these institutional fund houses to book profits and leave the market in a shambles to offset losses incurred on any other asset class.
With financial engineering reaching a new level, market watchers believe that more and more new structured financial products will expose financial markets across the world to newer challenges, which they were not aware of before, and should learn to absorb and mitigate such losses through better risk management techniques.
In February March this year, it was the excessive currency leveraging which resulted in unwinding of yen carry trade when the Japanese yen appreciated sharply against the dollar. Institutional fund houses, which had borrowed money in yen at a low interest rate converted them into a different currency and invested the borrowed money into a higher yielding asset, had to resort to selling equities to repay their borrowed loan when yen started to gain strength.
This time around (July-August), institutions resorted to a selling spree in equities to cover their losses incurred for their exposure in structured mortgage bonds in US. But still no clarity has emerged on those institutional investors, which has a higher exposure in the global real estate market. Already, real estate has started to show sluggishness in the UK and the US.
Now, the other major asset class that is being closely watched in the financial markets is the Mortgage Real Estate Investment Trust (MREIT). Fitch, a global rating agency, in its recent report has stated that mortgage real estate investment trusts that havent yet succumbed to the credit storm are struggling to secure funding and are facing growing liquidity problems.
Market experts feel it is still too early to say that the liquidity crunch experienced by mortgage real estate investment trust would result in another sell-off. But if the situation worsens, we may see the re-run of sell-off seen on the earlier two occasions.
For the time being, investors appear to have forgotten the enormity of the sub-prime crisis spilling over to the broader US economy and has got swayed by the 50bps point cut in the interest rate by US Fed Reserve. Now, with the consumer confidence level hitting their lowest level in the US and the US home sales figures showing a sharp decline in August 2007, global markets are on an upbeat mood as investors are betting on a further possible 25bps cut in the interest rate by the US Fed Reserve in its October meeting. Back home, market players already stunned and surprised by the fastest Sensex rally, have taken refuge in the economic theory of the demand and supply factor justifying the current rally. There seems to be a unanimous view emerging that with the India growth story remaining intact, there is a great demand for Indian equities from various categories of investors which is driving prices higher.
With uncertainties still looming large, it will be fair to say that with other factors remaining constant, the Indian equity market will truly reflect strong domestic fundamentals. Market experts say that as an open economy, we can no longer hide ourselves from the ups and downs in the global financial markets and should get accustomed to such intermittent shocks.