The ongoing sell-off in the stock market marks the eighth market correction that has interrupted the Sensex's four-year rally. The current decline, which has seen the benchmark index fall about 12 per cent since July 24, is part of the global market meltdown, as the US' "sub-prime" problems threaten to become a widespread epidemic. There is nothing yet to suggest that Indian companies will be directly affected by the sub-prime contagion. But the inf luence of global events on the Indian stock market performance has been steadily growing as foreign inflows have largely provided the liquidity that fuels the bull market.
How should Indian equity investors view the markets' vulnerability to global events? Is there a pattern to the "correction" episodes seen in Indian stocks that are linked to global factors? There is.
Going by previous instances, it appears that economic fundamentals matter little when FIIs take flight. Instead, they simply book profits on markets that have run up the most. Business Line analysed the performance of key global in dices vis-À-vis the Sensex during five corrective phases since 2004 to find out what is the common thread that runs through each of these global meltdowns.
Lesson 1: Fundamentals do not insulate Indian markets from global market sell-offs: Though "Fed rate hikes" and "Yen carry trade" may have entered stock market vocabulary only recently, India's link with o ther global markets actually goes back a while. In fact, every major correction in the Sensex since 2004 was amid a global stock market sell-off, triggered by events that led foreign investors to re-examine their exposures to risky assets, such as the emerging markets.
In 2004, for instance, the Sensex declined 27 per cent between April 23 and May 17. At the time, the volatility was attributed mainly to political uncertainty, following the change of Government and fears of a slowdown in the reforms process. But these may not have been the sole factors at play. The MSCI Emerging Markets Asia Index, for instance, declined 20 per cent during the same period. The Chinese Government had announced its intention to implement measures that would cool its overheating economy, sparking a sell-off across Asian markets.
In October 2005, again, markets weakened on concerns about further interest rate hikes by the US Federal Reserve. While we are fully familiar with the commodity meltdown and interest rate hikes across markets that triggered the massive correction in May 2006, it was Beijing's clampdown on speculation that set off another round of stock price declines in February 2007.
So if the prospect of leading mortgage lenders in the US going bust has you genuinely concerned about your own stock portfolio, your fears may not be unjustified.
Lesson 2: Sensex is among the more volatile indices: During such global corrections, most markets fall and recover at about the same time. The extent of the damage each market suffers, however, varies. In the five corrections observed, the Sensex has been among the hardest hit in every one, save the recent decline. Korea, Brazil and Indonesia are some of the other markets that typically bear the brunt of the volatility, as foreign investors have been chasing these markets as well.
However, the corrections so far have always been temporary, with the Sensex rapidly rebounding to its earlier highs and moving past it to newer levels. But this is not to say that India is the only market that has regained investor confidence.
The same holds true for other indices as well. As it turns out, when concerns at the macro level abate, foreign investors re-enter the very markets they exited. While Indonesia, Brazil and Russia underperformed the emerging markets group in the correction of May 2006, they more than recouped their losses in the subsequent recovery.
Lesson 3: Relative valuations do not count during sell-offs: One reason for this rapid recovery could be that the sell-offs seldom seem to be based on a reasoned view of economic fundamentals. We often hear FIIs talk of "expensiv e" Indian markets and the availability of more attractive investment destinations in other emerging markets. But, going by previous correction episodes, it is not always the most expensive market that gets bludgeoned the most.
In May 2004, for instance, the Indian market was not particularly expensive, compared to other emerging markets; the Sensex traded at a price-earnings multiple of about 15 times (trailing earnings) at the time. Yet it suffered the deepest correction.
In May 2006, Indian stocks had been re-rated and were definitely more expensive than other markets, enjoying a multiple of 22. And yes, it was hit the most in the subsequent correction. But, the rally that followed took stock valuations to even more dizzying levels by the end of the year.
On the other hand the Brazilian, Russian, the Philippines and Thailand markets, despite reasonable valuations, received an equal drubbing in the May correction.
China's markets appear to be dancing to a different tune altogether since 2006.
The Shanghai Composite has defied recent market corrections, even gaining amidst the latest sell-off by about 10 per cent. It continues to enjoy valuations that are completely out of sync with other markets, at about 49 times trailing earnings.
The absence of a connection between valuations and sell-offs seen in the above cases is not hard to explain. As it is often risk perceptions and liquidity that seem to trigger exaggerated market swings, economic fundamentals take a back-seat when investors decide to stay invested or exit a market.
Lesson 4: Higher the rally, sharper the decline: When FIIs turn risk-averse, they seem to first book profits in the markets where they hold the most profitable positions — meaning, the markets that gained the most in the precedin g rally.
In the May 2006 meltdown, it was markets such as India, Indonesia, Brazil and Russia that suffered the sharpest falls having been outperformerstill then (gaining 35-50 per cent since January 2006).
India's performance till July 24 this year lagged peers such as Brazil, Thailand, Korea and Indonesia. This could also explain why the Sensex has not declined as much as other emerging markets in the ongoing correction. These four were among the worst affected emerging markets in the recent carnage.
Lesson 5: Domestic factors could make things worse: While global market weakness exerts pressure on a country's stock market, domestic factors also play a role in magnifying the decline recorded.
For instance, October 2005 and February 2007 were weak months for emerging market stocks, in general. But Sensex declines were far more significant than those recorded by other emerging market indices.
In October 2005, India's widening trade deficit and the depreciating rupee were niggling worries for domestic investors and this led to local investors fearing a FII pullout.
In February 2007, another episode of unusually sharp declines in the Indian indices, interest rate hikes by the RBI and Budget blues exacerbated the losses sustained by the Sensex. In the light of above trends, what conclusions can investors draw about the ongoing stock market meltdown?
What's new this time?For one, this episode seems to mark a break from the past, the Sensex actually registering a lower decline than other emerging market indices. This time around, it is the European markets that are under greater selling pressure.
Going by past trends, this change is probably explained by the fact that the Sensex also registered a muted performance in the preceding rally. In turn, this relatively better performance could signal one of two things.
One, India, along with China, is being viewed as a lower risk exposure to equities, in general, and will thus continue to enjoy premium stock valuations.
Alternatively, the significant valuation premium India now enjoys relative to most other stock markets could lead to a slowdown in liquidity flows. For institutional investors looking to cherry-pick across emerging markets, there could be investment opportunities elsewhere.
Either way, interruptions in liquidity flows appear a clear possibility for the Indian markets in the coming weeks.
The best course of action for investors with a long-term perspective is to look at declines as buying opportunities in liquid stocks focussed on domestic themes.
However, more moderate return expectations may be called for.
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