Indian stock market booms, FIIs continue to buy heavily

The charge has been led by capital goods, metals, oil and gas and banking companies, while infotech, fast-moving consumer goods (FMCG) and automobiles have been underperforming. The surge has been driven by inflows of funds into the market due to a combination of favourable factors such as macroeconomic stability at home and global growth and liquidity, besides a weakening Japanese yen.

The ongoing capacity expansion in industry and infrastructure, the continued attractiveness of India for services outsourcing and the ability of the Indian companies to convert GDP growth into higher profits have been the major themes driving the current bull run.

Strong economy

Domestically, economic growth continues to be good, though slightly slower than the last year. The Reserve bank of India's conservative estimate puts GDP growth at 8.5 per cent in the current financial year, compared with 9.2 per cent in 2006-07. Industrial production has maintained double-digit growth in June. One must remember that Indian economy has achieved this growth momentum despite structural rigidities such as poor agricultural productivity, appallingly inadequate urban infrastructure, and shortage of urban land for industrial and residential needs. It is like running a marathon without shoes. As infrastructure improves, things can only get better.

The trend of hardening interest rates has not only been halted, there is also a distinct possibility that rates may ease in the near future. Concerns over inflation have abated somewhat. At 4.27 per cent, inflation based on the wholesale price index is well within the tolerance limit of the central bank. Coupled with the above-average monsoon, it suggests that the worst may be over on the price front. The Government's fiscal situation too, while not exactly in the best of shape, is far from setting off alarm bells among the investment community.

This seems to have led investors to conclude that clouds of uncertainty over corporate profitability have been lifted. The present valuations could be understood better in this light. The price-earning ratio of 21.5 implies that investors have based their calculations on expectations of corporate profits growing at an attractive rate.

Strong fundamentals and growth momentum have ensured sustained inflows of investment from abroad. Indeed, the much maligned foreign institutional investors (FIIs) have shown much greater long-term stability than Indian investors in buying and holding stocks. In the current calendar year, FIIs have bought shares worth $7873 million on Indian bourses. Of these, purchases of $3527 million were made in July itself. In comparison, purchases by mutual funds have been much smaller, Rs12.09 billion in the current calendar year. In July, even as the Sensex has been scaling new peaks, mutual funds have been net sellers to the tune of Rs0.833 billion. The foreigners, it seems, have greater confidence in India's economic success than Indians themselves.

However, the bright picture of the Indian economy is tinged with streaks of grey. The assumption that the inflation pressures have eased as have the prospects of an interest rate hike, may turn out to be false. The latest index numbers show a rise in inflation. While the Reserve Bank may not increase interest rates immediately, it is quite possible that it may do so before the end of the year, if inflation shoots up.

Many pivotal stocks that make up the market indices have failed to participate in the latest rally. Home owners are feeling the pinch of high interest rates in the form of larger monthly installments of loan payment. This is affecting consumption, especially of durables. The performance of the automobile sector has turned sluggish in recent months. The sales of two-wheelers have suffered a decline in the first quarter (April-June 2007) and there are indications that the slowdown will spread to cars, too. Automobile companies are not expected to do well.

The appreciation of the rupee is threatening to weigh down earnings of the software and pharmaceuticals companies. The software giant Infosys Technologies has disappointed markets by missing its first quarter sales target and projecting a sales growth of just 1 per cent in dollar terms for 2007-08. There is a concern that other software majors and pharma companies may report a similar trend in their April-June results.

Even if India manages to maintain a strong internal economic growth, it is now integrated far more closely with the rest of the world economy than a decade ago. International markets remain buoyant and have contributed to the surge in the Indian market. But there are reasons for caution.

Concerns over US economy

One such reason is the concerns over US economic growth and the sustainability of foreign investors' appetite for US assets. With the Federal Reserve maintaining a steady overnight interest rate while many other central banks are raising rates, the US currency has become less attractive to international investors. Moreover, the US has come to depend heavily on corporate bond inflows to make up its current account. In the 12 months to April, the US received $509 billion in corporate bond investment inflows that helped finance the current account deficit. Worries over sustainability of these inflows are reflected in dollar's weakness against other currencies.

Secondly, oil prices are creeping back towards a record high. They have touched $75 a barrel in London and some analysts, for example at Morgan Stanley, expect them to remain this high, perhaps nudging $80, for the rest of the year.

Finally, the weakness in Japanese yen, following Bank of Japan's decision to leave interest rate unchanged, may give a boost to "carry trade"-the strategy of borrowing funds in a low interest rate currency and investing them in a higher yielding currency. Carry trade pumps money into markets, but also aggravates volatility.

These reasons for caution-local and international-would imply a bumpy ride for the markets in the short term. Stock markets have a tendency to discount negative factors and bad news when the sentiment is buoyant. Till money keeps pouring into the market, no one bothers. Once the inflow stops, suddenly everyone awakens to their significance.

However, the markets have often confounded pessimists and there is no doubt that they will do so in the medium term. GDP growth is expected to top 9 per cent for the third successive year and per capita income might corss $1000 this fiscal. Savings and investments are around 35 per cent of GDP. These fundamentals would be great for the market.

What should then the investor do at current market levels? Should he stay invested or book profits? Is this a good time to enter the rally?

Investment tips

First of all, beware the plethora of new issues. Each boom sees a number of issuers of dubious repute vying for investors' attention and money. Investors who are beguiled by these boom-time creatures playing on their desire to make a fast buck have come to grief. Be extra selective in subscribing to new issues.

Secondly, there is no single rule that will tell you when the market will turn. For a retail investor it is becoming not just difficult but impossible to time the market. It is, therefore, advisable to take a disciplined approach and invest only through systematic investment plans for a period of three to five years in companies that are likely to participate in the entire development story of the country and grow more rapidly than the GDP. For the long term investor, the best is yet to come.