India's Market Turns Down the Heat

The freefall of the Sensex is indicative of a trend in emerging markets. It may lead to more reasonable valuations and good buys

It was the kind of gut-wrenching day that Dinshaw Irani would not like to relive. On the morning of May 22, as he watched the Bombay stock exchange go into a freefall, Irani, director of Bombay-based hedge fund advisor Artemis Advisors, had broken into a sweat and developed a severe headache. By mid-day, India's Sensitive Index, or Sensex, had plummeted 10%, to 10,045 points, and the frantic regulators halted trading for an hour.

To make matters worse, the air conditioning in Irani's office broke down along with the stock market. But by 1:30 pm, after the market reopened and was buoyed by buying from state-owned Indian institutions like the Life Insurance Corporation of India, Irani began to regain his composure. The market had recouped most of the losses by the end of the trading day. But that was cold comfort: the Sensex had cratered by 14% over the course of three trading days.

Foreign inflows of capital, which had pushed the Sensex to stupendous highs in early May, gave way to outflows. Things may not revert anytime soon. "Looking at the global scenario of rising interest rates and a firming dollar, I don't expect the big flows into India to come in the way they did," says Irani.


  The market upheaval in Bombay is just one act in a larger drama that has had global investors fleeing from emerging market stocks from Russia to Egypt in recent weeks. Since early May, the benchmark Morgan Stanley Capital International Emerging Markets Index, which tracks share price trends in 26 developing market around the world, has fallen about 14% (see BW Online, 05/23/06, "Emerging Markets Beat Quick Retreat."). That is one of the worst showings since the Asia financial crisis and Russian bond default of 1998.

Markets stabilized somewhat on May 23, and the Sensex finished up about 3% after Indian Finance Minister Palaniappan Chidambaram repeatedly reassured domestic and global investors that the India growth story is still strong as ever.

The big question going forward is whether the market drama in Bombay was a much-needed correction to an extremely overheated market, or a sign of deeper problems (see BW Online, 05/23/06, "Behind Emerging Markets' Malaise"). Right now, stock market lurch aside, India's fundamentals still look strong. The country is still home to excellent outfits such as Infosys (INFY) and Tata, which are among the best-managed companies in the emerging markets, while the country's youthful, and increasingly educated population remains a tremendous asset.


  Corporate profits are estimated to have climbed a little more than 15% in the fiscal year ended Mar. 31 -- a performance that is hard to match elsewhere in Asia.

Nor is it a big surprise. The Sensex was due for a bit of a shakeout, though few expected the market declines to come so dramatically in such a short time span. Successful big-ticket initial public offerings by the likes of Reliance Petroleum, hot money from abroad, and the growing participation of Indian local investors had all helped drive the Sensex to a record high of 12,612 on May 10, almost double the trading levels at the start of 2005.

In early April, the 30 companies in the Sensex were trading at an average of about 18 times their expected 2006 earnings -- one of the highest multiples ever and even higher than the average of about 15 for the Standard & Poor's 500 index (see BW Online, 4/5/06, "A Red Flag for India's Bull Market").


  Even so, the ferocity of the market declines came as quite a shock. Hospitals reported an increase in the number of brokers coming to them with chest pains. Police were put on vigil at high rises and bridges to prevent depressed investors and brokers from committing suicide. Investors walked around in a black cloud. For those accustomed to a stock market that has registered non-stop gains during the last three years, it was devastating.

The trigger for these recent declines had a lot to do with global market trends outside of India's control. The triple-whammy of rising U.S. interest rates, recent pull-backs in the white hot industrial commodity markets, and rising oil prices probably cast an unflattering light on India's Alice in Wonderland stock valuations.

It didn't help matters that on May 21, New Delhi sent out a circular suggesting foreign institutional investors would be taxed far more than the prevailing 10% rate on their capital gains from the sale of shares. That spooked the market, where foreign investors are an influential group. Separately, the high market had made locals careless: Brokers in India gave their blue chip stocks to banks and borrowed against them to invest in more speculative stocks. When the market began swinging last week, investors began selling at discounts in a panic, accelerating the downfall.


  Optimists point out that the market has still delivered double-digit gains in 2006, even taking into account the recent declines. "I'm not concerned," says Sanjeev Sanyal, chief economist for Deutsche Bank in Singapore. But others are less sanguine. "The next six or seven months will see a decisive slowdown," says Madhav Bhatkuly, director at New Horizon Funds in Bombay. "We will be lucky if we close the year in December in positive position compared to January."

Bhatkuly points to a more serious flaw underpinning the market's slide -- the deceleration of India's basic fundamentals. The market's rise was due mainly to the excess liquidity sloshing around the world which bought into emerging markets -- in particular the structural strength of India's listed companies and the country's inherent strengths.

The stock market high had made the government complacent. The Congress-led coalition in New Delhi has ridden on the market's effervescence for the two years it's been in office, with very little positive reform to show for their time. "They stretched the rubber band too far, and now there's no more rubber," says Bhatkuly.


  To keep India moving forward and get the stock market back on track, India has to implement long overdue plans. It must build out its poor infrastructure and abandon its socialist-era labor laws that don't permit companies to fire workers at will -- a rationalization of investment policies that are so twisted that foreigners have to invest in India through tax havens.

Instead, New Delhi's response to the stock market's dramatic fall was pedestrian at best. It ordered state-owned insurers Life Insurance and General Insurance to buy from the market. And all India's Finance Minister could say on national television was, "Don't panic, stay invested. We have strong fundamentals."

Investors aren't expecting much better from New Delhi in the future. The coalition government is supported by the Communist Party of India, which has made its dislike of foreign investors clear and which suggested the imposition of a higher capital gains tax on foreigners participating in the Indian stock market.

Nilotpal Basu, the Communist Party's representative in the Indian Parliament, blames the presence of foreign institutional investors in the market for its fall. "They are making and unmaking the market. They don't pay taxes like capital gains which are present everywhere, and they are emboldened enough to arm-twist the government," he says. "The small investor is the casualty."


  In all the mayhem, though, there is a little brightness. Investors can expect more reasonable valuations of Indian stocks. The market is now trading at a more realistic 14 times forward average earnings, down from 18 times two months ago. And some sectors are more attractive buys after the fall, says New Horizon's Bhatkuly.

State-owned banks, for instance, were late to the retail lending rush led by the private banks. So analysts say they will have a far stronger loan book in an era of tighter interest rates. Meanwhile, India's IT companies will do well thanks to a strengthening dollar and continuing global demand for outsourcing. It is hard to argue the outlook for India has been greatly diminished by the stock market blow-out. Yet there is no denying that some of the of the allure is gone from what, until recently, was one of the hottest stock markets on the planet.