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Rock Solid

| 11/15/2012 9:00 PM Thursday

A flood of money from overseas investors has entered the Indian market in a very short while. There are some imminent worries that this inflow could reverse. DSIJ analyses the issues at hand, concluding that the situation isn’t really bad.

“Markets are irrational”, “Exuberance is bad”, “Caution is the word”, “You can never time the market” – these are some of the most common admonitions you hear when the equity markets begin moving up. Should you ignore them and go out to invest so that you can ride the up-move from end-to-end? Or should you lend your ear to them and be careful so as to not burn a hole in your pockets and repent later? This dilemma is something that investors would be least inclined to pay heed to, particularly when the markets seem to be offering an opportunity to make profits. One way to get over this dilemma is to pay attention to the advice of the well-researched, and we would certainly not be out of line in taking credit for being one among them.

It was we who told you very early on that the Indian markets are beginning to gather steam for their next leg up. Since June, we at DSIJ have been the only ones to take a positive call on the market. No one, including the best market commentators and experts, was willing to take a firm stand on the future course of the market when we first wrote about an impending bull run. What has happened since early September 2012 is for all to see. We have been bang on target, and the market has been consistently rising since then. The Sensex has gone up by a good 12 per cent, coming reasonably close to breaking the proverbial glass ceiling and going past its previous peak.

While the good times are more than welcome, it does pay to look carefully for any signs of potential disruption, and this is what we seek to do here.

The government springing into action on the reforms front coupled with policy action in the US (read QE3) and Europe (the bond buying spree) are factors that have completely weighed the scales in favour of the bulls. The markets started moving up, and have not looked back since. While we expect the markets to scale newer heights going forward, as we mentioned earlier, it would be good to look out for any upsets in the onward and upward journey of the markets. All we are trying to do is to take lessons from history so that our readers can make informed investment decisions.

In our analysis, we have looked at two major factors that could, if at all, put brakes on the markets’ onward journey. The first and most important factor is with regard to the big FII investments that are coming in, which have the ability to keep the markets where they are and probably take them higher. The question is, will FIIs continue to invest in India? Are there any factors that may trigger their pullout from here? Are Indian institutions ready to take on the might of FIIs in case there is a need to do so? Secondly, is corporate India well on its course to improving its fundamentals?
Here is our take.

FIIs: Here To Stay

Remember the May of 2000, or even four years from then (17th May, 2004 to be precise). Does October 2008 ring any bells, or January 2009 for that matter? These were times when panic suddenly gripped the markets following events that weren't really expected to happen. Whether it was the unearthing of Ketan Parekh’s wrongdoings or UPA’s unexpected statements, the fall of the Lehman brothers or the undoing of the Raju’s (Satyam), these events have rocked the markets. Typically, one fallout of events like these is the massive pullout of foreign funds (FII investments) that primarily drive the Indian markets.

The markets’ rise can largely be attributed to the flood of FII money that has come in over the past couple of months. This stands true because retail participation in the markets has not been anything worth talking about.

Thus, there are worries about what could happen in case these funds are withdrawn at the same speed at which they have come in? Will this really happen? What could trigger such a pullout? Most importantly, if they do, is there a viable alternative to FIIs in the Indian context?

The impact of FII flows and the returns given by the Indian equity market is more like a chicken and egg conundrum. It is very difficult to interpret whether FII inflows push the markets up or whether FIIs come in to take the advantage of rising markets. However, various research papers have confirmed that it is the better performance of the Indian (or local) equity markets which plays the most important role in attracting FII money, and not the other way round.

However, if some tail risks emerge once in a while it may lead to a huge outflow of FII money, thereby impacting the equity markets. For example, in October 2008, the Lehman Brothers crisis led to a net outflow of Rs 15347 crore in the same month. This stands to be the highest withdrawal of money by FIIs in any single month till date. The impact of such a huge outflow was reflected in the performance of the Sensex, which saw a sharp drop of 25 per cent, once again the worst monthly fall seen since 1997.

Are we currently faced by any such events? Well, we do not believe so, and hence feel that a sudden exit of FIIs looks unlikely. Year-till-date, FIIs have invested more than USD 18 billion in the Indian equity market. The sheer quantum of this amount is at the heart of the fear of any negative event impacting the equity market and triggering a massive outflow of funds. Some of the risks in the offing which could trigger such an outflow include an early union election, a sudden deterioration of the situation in Europe or the US going down the ‘fiscal cliff ’, as is being perceived (See our Special Report on fiscal cliff).

However, past experience shows that there is a disproportionate reaction of FIIs to good situations as well as bad ones. When the economy is doing well, FIIs intensify their buying, as we saw in the calendar years 2009 and 2010. The year after the financial crisis of 2008 saw the economy picking up from a low GDP growth of 5.8 per cent in the second quarter of 2009 to 9.4 per cent at the end of the second quarter of 2010. When this happened, FIIs pumped in close to USD 17 billion and USD 29 billion in the years 2009 and 2010 respectively, which was a sort of a record inflow. However, the situation deteriorated over the next couple of years, with the economic growth rate dropping to 5.3 per cent in the second quarter of CY12. Despite this, we did not witness any massive outflow of FII funds from the Indian markets. Although FIIs did exit from the Indian market, the outflow was a mere Rs 2714 crore. Against this background, we believe that FIIs will be not in a hurry to exit the Indian equity market en masse even if the situation worsens from here on for any reason. 

Stocks Where FIIs Have Increased Their Stake

In the quarter ended September 2012, FII holdings have gone up in four out of every five Nifty stocks, going down in just three stocks and remaining unchanged for the rest. This speaks of an overall positive mood of FIIs for India Inc. at large.

 

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