Indian stocks take a break from the Dow

It was a stormy relationship until it broke up. The Indian stock market has always stayed faithful to gyrations in US equities — we saw it in the bull market to 2007 and then during the 2008 meltdown. But recent trends suggest that this relationship may now be weakening.

Between November 2010 and July 2011, while the Sensex dropped by 11 per cent, the US bellwether Dow Jones Industrial Average actually took the opposite direction, creeping up by 9 per cent.

That is what is captured in the ‘correlation' (a measure of how much one index is influenced by changes in another) between the Indian and US stock markets moving to a negative 0.6 in this phase, after staying at a positive 0.8 for most of the last five years. We used the MSCI indices to run a correlation analysis between India and other key global markets.

Now, the crucial question is: Will Indian markets recover when the US picks up again or will it continue its downtrend in isolation? To answer this, we may first need to look at why the Indian market may have behaved differently from others in the November-July period.

Rally in commodities

Following the unrest in the MENA (Middle-East and North Africa) region which led to fears of supply disruption in oil, crude oil price rallied 31 per cent in the November 2010-July 2011 period.

India has the least to gain from rising oil and commodity prices among the BRIC nations. The country imports close to 75 per cent of its crude oil requirements and has more commodity users in its key indices than mining or commodity companies.

The crude oil price rally fired other commodities too. The Reuters CRB Commodity index, which is based on future price of 19 commodities, rallied 13 per cent in the November 2010-July 2011 period. With prices of input commodities rising, investors got wary about Indian equities. The caution was understandable. Between March 2007 and September 2008, when commodities entered bubble territory, BSE-500 companies saw their profit margins drop by six percentage points and net profit fall 27 per cent.

Rising commodity prices saw investors abandoning Chinese stocks too. The Shanghai Composite index was down by 12 per cent (at par with Indian markets) in the November-July period. However, investors bullish on commodities did a portfolio rejig in favour of other BRICs, reports EPFR Global, a research house that tracks global fund flows.

With Russia holding the world's largest oil reserves next to Middle East and Africa, the Russian equities market saw good inflows in this period.

High inflation and interest rate

With rising energy and commodity prices, food inflation also escalated in India between November and July. Even as the Consumer Price Index averaged a 9 per cent increase in this period, food inflation measured by the Wholesale Price Index touched 20 per cent in the last week of December 2010.

To counter rising inflation, the Reserve Bank of India (RBI) began raising key policy rates. Between November 2010 and July ‘11, interest rates were raised six times, with the repo rate rising 200 basis points to 8 per cent in this period (in the last interest up-cycle in 2008, the repo rate hit a high of 9 per cent).

The end to India's easy money policy even as markets such as the US retained rates at historic lows, stoked fears of rising borrowing costs hurting growth for domestic industry.

This was reflected in the Index of Industrial Production (IIP) weakening from the beginning of 2011. In the March 2011 quarter IIP growth fell to 7.8 per cent versus 14 per cent in the same period of 2010; in the June quarter the growth was 7 per cent versus 10 per cent in the June 2010 quarter.

Interest rate risks were also seen to be high for Brazil, and its stock market was beaten down by 18 per cent in the November-July period.

Lower earnings

Attribute it to higher input costs or slowly rising interest rates, India Inc's quarterly report card began to lose sheen from the December quarter of 2010.

Earnings slowed from an annual growth of 21 per cent in the December-2010 quarter to 13 per cent in the March-2011 quarter and a modest 5 per cent in the June-2011 quarter for the BSE-500 companies.

Profit margin at the operating level was down three percentage points (to 25 per cent) in the June 2011 quarter compared to the December-2010 quarter. In the previous commodity rally in 2007-2008, operating profit margins touched a low of 23 per cent for the same set of companies.

Governance issues in corporate India

The chain of arrests that followed the housing loan scam and the 2G spectrum investigations did their bit to create doubts in the minds of foreign investors and resulted in the abrupt de-rating of stocks across sectors such as telecom, realty and banks.

Though the issues were specific to companies, it left a larger impact. Business Line's analysis also found that foreign institutional investors exited the controversial stocks in large numbers between December 2010 and March 2011.

FII holdings in Unitech and DB Realty dropped from 34.6 per cent and 7.7 per cent in end-September 2010 to 31.7 and 5.5 per cent, respectively in March 2011. The political environment too has not been conducive, with the many allegations of corruption against the ruling coalition.

Currency- no incentive

A strong rupee has always been an attraction for global investors to invest in India, as it bolsters their investment returns. But the rupee has stayed flat for much of the November-July period, at about Rs 44 against the dollar.

In the 2007 rally, the currency equation was favourable to India.

That year, the INR appreciated 11 per cent against the dollar and closed the year at 39.4. SEBI reported a net inflow of Rs 71,487 crore from foreign institutional investors for 2007.

Pre-conditions for India recovery

From the above, the following may be the two necessary conditions for a stock market recovery in India:

A cooling off of commodity prices, particularly that of crude oil.

A pause in the RBI's rate hike cycle. Though the lag effect of recent hikes may continue to be felt for some time, an end to rate hikes will have investors taking a more positive view of next year's earnings.

In PE (price-earnings) terms, the Sensex trades at a price-earnings multiple of 14 times estimated 2011-12 earnings. This is still at a premium to the Emerging Markets pack (China's Shanghai Composite at 11 times, South Korea's KOSPI at 8.5 times and Taiwan's TAIEX at 12.7 times) or the US (Dow Jones at 10.7 times) itself.

India's (Sensex) earnings growth for FY12 is estimated at 7 per cent against 18.4 per cent growth for China (Shanghai Composite) and 15.5 per cent growth for the US (Dow Jones).

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