The latest decline in the Indian stock market coupled with the unraveling of the Greek sovereign debt crisis have raised the spectre of a double dip recession.
And investors are running around for answers as only a few weeks ago Nifty looked poised for a fresh high. However, the optimism was affected by a poor show by the Euro zone and its contagious impact on global investors.
Foreign institutional investors (FIIs) have suddenly turned net sellers on Indian bourses while domestic mutual funds (MFs) continue to sit on the fence. Meanwhile, corporate earnings have been patchy so far with no certainty about the year ahead.
Amid all this, investors would do well to make stock specific calls rather than taking a market view. But before you open up your wallet to make fresh purchases, let’s pause and run a diagnostic check on the Indian equity market and the factors that drive it.
The stock prices are primarily driven by two factors, underlying earnings growth (of listed companies) and the liquidity flow or the amount of purchasing power of investors/traders.
While the former acts a push factor, the latter pulls the market up as cash-rich investors bid-up stock prices. So to get a handle on the current wobble on the Dalal Street, we need to get to the bottom of these two factors.
Let’s handle the liquidity factor first. The two sources of liquidity (or funds) for Indian equities are, domestic and foreign. The key domestic sources are retail investors, mutual funds (MFs) and insurance companies.
Of these, MFs and insurers play the most important role given their size and influence on the market. Foreign money primarily comes from institutions investors (FIIs) and they now collectively account for nearly a quarter of the fund flow on the Indian bourses.
The chart (Fully Loaded) shows the historical movement in the cumulative FIIs flow and MFs investments in the equities. As the chart shows, on a cumulative basis, the FIIs inflows into India remain strong despite the recent wobble on the Street.
In contrast, domestic MFs have been net sellers on the market since September last year. The corresponding data on insurance money is missing but, it is most likely to be positive or at worst stable since, insurance premiums are committed expenses and their flow doesn’t change much in the short-term.
On the balance, however, more money has flowed into the market in the past 12 months compared with the cash that has gone out.
This probably explains the continued positive bias on the Street despite the occasional bouts of sell-offs. In May so far, however, FIIs have been net sellers and this is the reason behind recent market correction. The future course of the market will be greatly influenced by liquidity flow on the Street in the coming weeks and months.
Domestic liquidity is greatly influenced by the Reserve Bank of India’s monetary policy. Right now, there is an uncertainty regarding monetary tightening.
The central bank has not been very aggressive in addressing high inflation. It hiked the key interest rates and cash reserve requirement moderately, leaving the systemic liquidity almost unaffected.
But, headline inflation is still hovering in the double-digit zone and there are no signs of easing up of inflationary pressures.
Despite new rabi crop arrivals, food prices continue to remain at higher levels. And now rising raw material costs have pushed up prices of manufactured products.
RBI has clearly hinted in its latest policy document that aggressive measures could not be ruled out if inflationary pressures continue to be high. And if that were to happen, domestic liquidity could be sucked out, adversely affecting equity markets.
Lack of domestic liquidity could be compensated by higher inflows of FIIs money. This, in turn, depends on global liquidity position.
Global liquidity is broadly defined as money supply (M2) growth in the G-4 countries, Japan, the euro zone, the UK and the US.
The bail out packages given by these countries during the financial crisis resulted in a surplus liquidity globally, which has spilled over to emerging markets. These countries have not yet started withdrawing cheap and easy money from the system. As a result, foreign capital inflow continues in emerging economies.
However, inflation is now rearing its head in most major economies and this may push their central banks to withdraw easy monetary policies soon.
In that case, emerging markets, such as India, could see a reversal in capital flows, hurting the domestic equity market.
According to an International Monetary Fund (IMF) study, a 10% decline in global liquidity growth is associated with a 2% decrease in equity returns of the liquidityreceiving economies, which are essentially emerging markets.
The other global factor is the potential loss to the global banking system from any possible sovereign default in Europe.
Most global banks and large asset managers, such as pension funds, have big exposure to the European sovereign and if they face a haircut in Europe, they will be forced to repair their balance sheet by selling in other markets.
And even if the default is averted through timely intervention, the global investment climate has been vitiated and investors would be risk-averse in the near term. This is not a great recipe to attract FIIs into the Indian market.
Liquidity becomes a minor issue if an asset shows the potential for higher future earnings. This is especially true in case of equities as it not only provides capital appreciation to investors but also offers the possibility of earning recurring dividend income.
So in the long-term, the equity prices should ideally track the growth in corporate earnings and other financial indicators.
This is shown in the adjoining chart where we have plotted the historical trend in Nifty value against its earning per share, book value and dividend per share.
All indicators are based to the value 100 on January 1, 1999, and thus show their relative movement over the years. The latter three indicators are derived by inverting the Nifty’s readily available valuations ratios such as P/E multiple, price to book value and dividend yield.
The chart shows that, even after the recent correction, Nifty is trading ahead of the underlying fundamentals. This would not have been a major issue if India Inc’s growth momentum had remained intact.
As the chart shows, there has been an absolute decline in Nifty’s EPS, book value and dividend per share in recent months. And there are no immediate signs of a trend reversal either.
The complete picture would, however, emerge only after the current earning season that ends this month. So far, earning growth has been patchy and pockets of good growth such as shown by the auto sector have been undone by laggards like cement. And in many sectors, the growth has been aided by non-recurring factors such as low-base effect.
The silver lining, however, is the fact that that Nifty EPS has been highest in over two years, implying that most companies have recouped the losses they suffered in the late 2008 and early 2009. It is yet to be seen how the new fiscal pans out for India Inc amid global macroeconomic uncertainty.
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