Alarm bulls in our stock markets

For 15 weeks in a row, the Indian stock markets have been on a roll and the Sensex and Nifty have scaled new highs. The Sensex is within striking distance of the 8,000 mark and the Nifty is close to 2,400. The length of the rally has been unprecedented. Those who bet on bearish outcomes have perished and bulls have stepped over all the bad news over the past few months with aplomb and determination. Having said that, questions about sustainability of the current rally remain and its implications for investors need to be understood.

Since the third week of April, the Sensex has moved up by over 25%, gaining over 1,700 points, to rise from around 6,100 to the peak of over 7,800. Two things have happened in this period to push the market to uncharted territory. One is a robust inflow of foreign money, as more and more FIIs have rushed to pump money into the Indian market. What is new about these inflows is the decisive move made by Japanese funds to look at India as an alternative to China, following the spat between Japan and China over history textbooks and territorial rights over some islands in the South China Sea. The growing hostility between Chinese and Japanese nationalism on these issues has motivated Japanese investors, (who sit on huge reserves and face near-zero interest return in their country) to reduce their exposure to China. Not surprisingly, the bulk of the $ 1.9 billion that has flowed into Indian markets in July alone has come from Japanese FIIs, taking the total FII investments in 2005 to around $7 billion. The number of new FIIs registered during the year has also gone up significantly.

The second feature is the reaffirmation of the Indian growth story. While it is true the markets have been driven by huge liquidity, the fact is that this liquidity is chasing better growth relative to what is available across emerging markets. The character and size of India?s growth is next only to China?s and the moment there are question marks about China, India begins to look very attractive. The upswing in the Indian economy that began in 2003, when GDP grew by 8.4%, has been followed by 6.9% growth in 2004. And, projections are that 2005 may see an improvement to 7.2%. Even more heartening is the upswing being reported in manufacturing, that has begun showing double-digit growth after languishing for nearly a decade since the boom of the mid-90s.

There are reasons why growth now looks more sustainable than in the 90s. First, infrastructure and construction has begun to draw a lot more investment than five years before. This will not only add to the growth rate, but also generate more demand for manufacturing output, both directly and indirectly, through job and income growth. Second, middle class expansion is acquiring a momentum of its own. New entrants to the salaried class are leveraging their incomes to consume at a much higher level, thus adding to the demand for goods and services.

Third, though investment in manufacturing has picked up, its rate as a percentage of GDP is much lower than in the mid-90s, and looks much more sustainable. Investment behaviour is not frenzied as in the 90s, when huge over-capacities were created. Fourth, the IT and telecom and services growth story remains intact and is spreading to new service segments, such as tourism, civil aviation, logistics, healthcare, etc. Fifth, Indian business, and particularly manufacturing, is generating much more revenue through exports than it did earlier. While growth is led by domestic demand, exports are increasingly adding to the bottomline. Sixth, the dependence of the rural economy on agriculture is reducing, as secondary and tertiary activities are increasingly contributing to rural output and growth. Sixth, after being neglected for long, reforms are finally being spread to the farm sector. In coming years, this will bring diversification of farm activity. Finally, the proportion of Indian savings flowing to the stock market would rise substantially in coming years, as investors become more aware and develop more confidence in our regulators.

Arguably, the Indian economy is on an inflexion point, just the way China was around 1993, when it took off into rapid growth. And unlike China, India is displaying a lot more entrepreneurial energy and creativity. Against this backdrop, it is reasonable to expect that earnings of frontline companies making up the Sensex and the Nifty would sustain growth of 15-20% over the next two-three years. Some mid-cap counters could see earnings growth of even more than 30%.

Here lies the rub. While the growth story remains intact, corporate India will be subjected to harsher competition in the days to come. Mid-cap players will challenge existing leaders and the stock market will enable this by creating more opportunities for raising money to fund growth. Further, as Indian firms globalise to generate more revenue, they will be increasingly prone to risks of the global marketplace and its ups and downs. While corporate earnings will continue to grow, the risks of achieving that growth will get higher.

Therefore, investors will have to tread carefully. This 15-week-old rally will surely see a correction, but it appears markets are on the threshold of a three to four-year bull run driven by India?s growth and more money, both domestic and foreign, flowing into equity. These corrections should be used to buy into firms with a growth story. It is important that investors behave like investors and not traders, as markets will display volatility and short-term speculation could be dangerous.

The writer is an advisor to Ficci. These are his personal views