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Writing in the Street

Everybody is just curious to know what lies ahead in 2007. Will the markets keep rewarding investors?

The New Year bash at my neighbour Mr Keshavbhai's house has become the most awaited event in my neighbourhood. And guess what has transformed a once-miserly Keshavbhai into a party animal? He is a big stock investor. These annual extravaganzas are more a celebration of his stock market feats rather than the coming year. And this year was no exception. An over 40 per cent appreciation for the second consecutive year surely called for some celebrations! And as some of the most expensive wines kept flowing, the tales of his biggest stock bets and how he made millions out of them kept everybody fascinated through the night.

But as I sat the day after, trying to get rid of the hang-over and humming the tune of 'Put on your dancing shoes….' (which happened to be the most requested song the evening before), an intriguing thought crossed my mind - will these festivities continue? Will 2007 be another rocking year for the stock markets? What kind of a mood will Keshavbhai be in on December 31, 2007?

At a fundamental level, there are only two aspects which make a strong case to buy into equities. Either the markets are grossly under-valued and the stocks are available at compelling bargains, or the companies are on a high growth trajectory so that even after factoring in rich valuations, there is a lot of upside potential.

However, building a case for stocks on the grounds of attractive valuations at a time when the Sensex PE is well beyond 20 looks unjustifiable. At such valuations, large Indian stocks are among the most expensive ones in the world. And are Indian mid-cap stocks cheaper than large-caps? Superficially, perhaps they are. Generally, it is believed that the quality mid-cap companies have a better chance to record higher growth rates on a lower base, and therefore they tend to command a premium over the large-caps. But in the Indian markets, this does not seem to be the case, since even the large companies have been witnessing phenomenal growth rates over the past few years. And the markets do seem to be putting a higher premium to their stability and earnings visibility.

Table Fact Sheet presents the compounded annual growth rates of net sales and profits, along with the median PE ratios of the constituents of the BSE 200, aggregated into three market capitalisation categories (excluding 29 stocks for which figures were not available). Though the stocks of smaller companies appear to be cheaper than the large-caps, but they don't seem to be available at scorching bargains.

The real story lies in the first two columns of the table that is -growth momentum. A look at the kind of growth in sales and profits that India Inc has registered over the past three years suggest that these fantastic stock market returns are no flash in the pan, but based upon strong fundamental variables. And the story does not end here. There could be quite a while before this Indian juggernaut runs out of steam. The order books are over-flowing and more and more domestic companies are making their mark across the globe.

Even at the macro level, things are going well. For the third successive year in 2005-06, the Indian economy grew by leaps and bounds. GDP has recorded growth rate of 8.5 per cent, 7.5 per cent and 8.4 per cent in 2003-04, 2004-05 and 2005-06, respectively. In fact, the last quarter of 2005-06 was exceptionally good as the GDP touched a growth rate of 9.3 per cent. Moreover, such a high GDP growth rate has been achieved while keeping inflation within the RBI's comfort level of 5-5.5 per cent. Going forward, the outlook for GDP growth rate continues to be a strong 8 per cent or more. This looks modest in front of the 9 per cent envisaged by the Eleventh Plan, and the Finance Minister's statement that the economy could accelerate to more than 10 per cent per annum for the next five years. If such a growth momentum can be maintained, then there is little reason to be pessimistic. While all these variables paint a fairly positive picture, is there anything that can go wrong?

The main concern is that at current valuations, overly robust growth rates in corporate earnings are already priced into the markets.

And therefore, till the time things remain the way they are, there is little to worry. However, any slowdown in earnings growth can trigger a market fall.

The growth momentum can lose steam if the central bank opts for a tighter monetary policy regime. A few days back, the RBI had surprised everyone by announcing a hike in CRR. The move is largely targeted to restrict the lending capacity of banks. And its impact on the markets, though for a short while, was quite drastic. The Sensex shed over 800 points in a space of two days after the announcement. The RBI is already increasing the interest rates over the past few quarters. There has been a hike in the repo rate of 25 basis points each in the last four policy reviews to 7.25 per cent. Whether there will be further hikes or not will depend upon the central bank's tolerance of inflation. Though it has been benign so far, it has gradually inched closer to the 5.5 per cent mark, beyond which the central bank might tinker with its policy. While the markets are already expecting another rate hike in the forthcoming January policy review, any such subsequent hike may cause some flutters.

Many analysts and portfolio managers do not consider that to be a major threat. The consensus is that interest rates are not likely to rise significantly. And any marginal rise is unlikely to hurt earnings growth in a big way.

Apart from that, any global events like an oil shock or the US slowdown can also have an impact on the markets. This happened in May 2006, when a meltdown in metals sent the global markets into a tizzy. And the Indian markets were no exception to that.

The Liquidity Factor
Liquidity is the essential fuel that propels the markets to newer highs. And the Indian markets have been blessed with abundance of liquidity in the past few years. Till 2004, FIIs were the single dominating factor in the markets. But in the last two years, domestic mutual funds have also emerged as a strong player in the markets, thanks to huge NFO collections. But would these trends remain favourable going forward?

Well, the situation does not look all that favourable for the mutual funds. There might be a slowdown in the amounts raised through the new fund offers because of the introduction of MIN (Mutual Fund Identification Number). Effective from January 1, 2007, investors investing Rs 50,000 or more in the mutual funds will have to obtain MIN. This requirement can put the brakes on NFO mania and fund houses might actually refrain from launching new funds till a reasonably large number of investors have acquired their MINs.

Secondly, with the kind of gigantic sizes that many new and old funds have acquired, it would be extremely difficult to manage the expectations of the investors. Beating the markets while being saddled with huge asset size will be quite a task from here on. And if the funds fail to deliver the kind of returns that the investors have grown used to (which is very likely to be the case), it will be difficult to woo them again and again. Therefore, the ability of mutual funds to influence the markets might diminish from here on.

However, the scenario for FII inflows looks much more cheerful. Though investments by foreign investors witnessed a marginal slowdown in 2006 (see table Robust Institutional Investment), there are no signs of a real reversal. As long as the growth story remains intact (India is currently the second fastest growing economy behind China), FIIs will keep flocking to the domestic shores.

Selectivity is the Key
Did you know that while the Sensex gained over 40 per cent in 2006, as many as 1,200 stocks out of the 2,400 odd traded on the BSE ended the year in red? That is exactly half the stocks! Prune the list down to include only the stocks with a market cap of Rs 100 crore or more, and you will find that a significant 368 out of 951 such stocks ended 2006 in the negative territory.

This is a significant increase in comparison to the previous two years. In 2004, just over 400 out of 2000 stocks (or 20 per cent) ended in red, while in 2005 about 550 stocks out of 2200 (25 per cent) ended with losses. This implies that after a prolonged bull run, more and more companies are running out of steam.

The lesson is clear - while the stock markets continue to rock, there is a high probability that you can actually end up with losses by being careless while choosing stocks. Just because markets at large have undergone a tremendous bull run does not mean that all and sundry will keep going up. The initial euphoria can pull anything and everything to dizzying heights, but we are well past that stage. And all those who believe that they possess Midas-like powers will be in for a surprise. Going forward, as the markets scale new highs and the growth rates start peaking out, the importance of selectivity will only increase.

Conclusion
While the odds are still stacked in favour of the bulls, volatility is likely to be high. Even the slightest negative news flows would have the potential to cause huge market gyrations. Inflation, interest rates and corporate earnings are likely to be the key variables to determine the course of the markets. While there are all the reasons to stay invested, being cautious and selective will help you steer clear of inherent dangers. One can reasonably expect that Indian equity markets will end the year 2007 with gains, but expecting those gains to be to the tune of 40 per cent yet again is wishful.
As for Keshavbhai, I'm not too sure if I'm looking forward to his party next December.