Balancing act

There are quite a few factors that call for caution in this market. First, FIIs have not been buying in a big way and they have been net sellers in both nifty futures as well as stock futures in the past few days. The buying seems to be more arbitrage-driven than genuine buying. Volumes continue to be low and delivery volumes in particular are very low. The mid-cap and small cap indices have performed better than the large cap ones. In the futures segment, open interest has gone up substantially, indicating a lot of fresh positions being taken at current levels. Mutual funds are net sellers on most days. So who’s buying? All the data point to local punters, who have once again become bullish on the market.

Nevertheless, not all of it is froth. Part of the reason for the improvement in sentiment lies in the better-than-expected first-quarter corporate results. The rise in many small and mid-cap stocks, for example, is based on the fact, as BRICS Research put it, “the mid-cap universe showed significantly better results than the sensex/nifty companies at an aggregate level”. And further, “half of the 398 small-cap players reported strong earnings growth, with net profit more than doubling for 74 of them and 16 companies staging a turnaround in Q1FY07.”

But as a recent India strategy report by JP Morgan says, while consensus earnings estimates for the MSCI India universe of companies have been revised up by 0.4 per cent, the market has gone up 14 per cent. Further, the report also says, “The performance of sectors with positive earnings revision has been mixed — telecoms outperformed the market, while IT services, healthcare and materials performed largely in line. Surprisingly, the sectors with negative earnings revision i.e. financials and industrials have outperformed significantly, albeit off a low base and beaten down valuations.” The report puts the market bounce down to global cues. That may be true, but it’s also a fact that when everybody expects a downward revision in earnings growth, an upward revision, however minor, is a big boost.

Of course, the lack of conviction is a feature of markets all across the world at present. Money has started flowing into emerging market funds, but many of them continue to sit on cash, waiting for some confirmation on the direction of the market. Hedge funds too are not leveraging to the extent they can. But then, as one hedge fund manager put it, worry has been a constant feature of the bull run ever since 2004, when US interest rates started rising.

Currently, with the US Fed Futures indicating a very low probability of the Fed raising interest rates at its next meeting, the concern is not about higher interest rates but about lower US growth. But surely, if growth slows, all that the US central bank has to do is slash rates? Not everyone believes that will help. Economists such as Morgan Stanley’s Andy Xie believe, “A US slowdown, when it occurs, may not be sufficient to bring down inflation. Asia dragged down inflation in the US 10 years ago despite its strong economy. As Asia turns to inflation from deflation, US inflation could remain high despite its weak economy.” That’s the stagflation that many economists are forecasting for the US economy, particularly with oil prices so high.

Of course, if a slowdown does occur, India is relatively insulated, thanks to its dependence on local demand to fuel growth. The question is: will the Indian market have the strength to decouple from other, more export-dependent emerging markets?