The way markets have moved up sharply, almost doubling in just three months, has not only baffled analysts but also left investors worried. It is quite strange that investors panic not only when the markets are falling sharply but also when they are rising sharply since they did not get the chance to make an exit and enter at the opportune time. Going by the queries I receive, investors are desperately trying to catch up with the markets and this might prove really dangerous.
India has performed better than most other markets simply due to the combination of liquidity and the premise that it is likely to grow faster than most other countries. The government and the central bank are likely to continue pumping in liquidity, which in the event of not being used for turning out goods and services is likely to push up asset prices further. The rise in liquidity has been reinforced by the return of risk appetite due to initial economic data that has been encouraging and the re-election of the Congress-led government. India is therefore quite well placed to achieve a domestic demand-led growth rate of 6 per cent or so.
The absence of inflationary pressures gives further leverage to the government to keep interest rates low. The present favourable market conditions and increased capital inflows can take care of near-term financing needs. The government has a unique opportunity to address structural issues, at least in the initial period of its five-year term by taking bold and credible policy action. In all, it appears that the worst is over for the markets and we can soon be on the way to a speedy recovery and high growth. But a sharp rise in stock prices, to as high as around 20 times the past earnings, has raised doubts about the sustainability of valuations. Mid and small cap stocks have run up way ahead of the bench mark index with many of them going up three to four times from their lows and include very high-risk and highly leveraged companies.
To justify these kinds of valuations, the economy needs to grow at double digit and corporate profitability has to grow at a much faster pace. Some of us may argue that the run-up in the stock prices has come on the back of beaten down valuations and extreme pessimism. But, since the fall was so sharp and sudden, the initial rally had to be equally sharp and sudden. However, a look at the current scenario may make us tone down our expectations.
The fiscal deficit for the first month of the current financial year has shot up to Rs 54,100 crore which is 16.3 per cent of the projected deficit for the entire year. Government spending in April 2009 almost doubled from the same period last year and tax receipts fell by 32 per cent on year-on-year basis. Large government borrowings can cause interest rates to go up sharply. With commodity prices also moving up, the margins for corporate India may come under severe pressure despite pick-up in demand.
Besides uncertainties regarding the pace and magnitude of global economic recovery that may directly impact our exports, investors are also worried due to the bleak outlook of the monsoon. This may push up food prices and prompt more government spending to support farmers and implement social security programmes. On the other hand, rising oil prices may further worsen the fiscal deficit and directly impact some sectors more severely due to rising costs and rising interest rates.
The Budget is also not likely to cheer the markets in a big way. In keeping with the social sector priorities of the government, the Budget will have to raise additional resources by obviously increasing taxes. Moreover, excessive supply of equity in the short to medium term could prove a further dampener. The current political turmoil in the immediate neighbourhood is another cause of worry.
Also, at the present valuations, international investors may not be keen to increase their allocation for India. This may be due to the lower investible funds available in general and the lower likelihood of spectacular growth in profits for corporate India. Any further unfavourable development in global markets may cause a sudden set back to the flows. This gets amply reflected by the recent behaviour of FIIs who have not only been sellers but have taken increasingly short positions at the time of writing.
In view of this, small investors are advised to be extra cautious at least in the short term but may use any sharp correction to enter and increase their exposure. A time horizon of less than three to five years is most likely to betray your expectations of earning decent returns from the equities.
The Budget is also not likely to cheer the markets in a big way. In keeping with the social sector priorities of the government, the Budget will have to raise additional resources by obviously increasing taxes
The author is retired as Professor from the University of Delhi in 2024. He is an alumnus of IIM Indore and holds a PhD from the Delhi School of Economics. An investor activist and former member of various SEBI committees. He taught Capital Markets and Investment Banking at leading business schools of India.
