Dramatic turnaround

In early 2009 Indian equity markets were recovering from the lows of October 2008. However,in early January corporate fraud was unearthed at Satyam Computers. Sentiments,which were already negative on account of the global financial crisis,turned even more so and caused the Indian markets to decline further. Hence,in the first quarter of 2009 the Indian equity markets were one of the worst-performing among emerging markets.

…And sharp rally thereafter

Gradually,however,stability in the Western worlds financial markets coupled with massive injection of liquidity led to optimism returning to equity markets across the world. Globally,equity markets have rallied sharply after bottoming out at the end of Q1 2009. Indian markets,too,have rallied sharply,more than doubling from their March lows. The rally in our markets has been brought about by strong responses from the government and the monetary authorities,which have revived industrial demand. Moreover,the election of a strong and stable government (sans the Left parties) further boosted sentiments and drove the markets higher. In fact,the Indian markets created history when they hit the upper circuit after the outcome of the national elections were announced.

What has changed?

If we analyse what has changed during the current year compared to last,it is primarily sentiments. And what led to this change of sentiments,one may ask. We believe sentiments have changed because more good news has flowed into the markets compared to bad.

Economic data from the Western world appears to suggest that the fall has been arrested and those economies have stabilised. Industrial production has been gaining momentum month-on-month,consumer confidence is reviving,residential real estate prices have stabilised and have even started rising marginally. All this good news has lent strength to the equity markets and enabled it to sustain at higher levels.

In India,too,industrial production data points to a sharp recovery in demand. GDP growth forecasts by various research agencies have been pegged at 7-7.5 per cent for FY10. This has been possible mainly on account of strong domestic consumption demand coupled with enhanced government expenditure on social schemes directed at the rural masses.

The risks ahead

Massive government expenditure and large doses of liquidity have brought about economic stability in the US and the Euro zone. While the economic downturn has been arrested,it cannot be convincingly declared that these economies are out of the woods. Only when employment opportunities improve in those countries will it be possible to say that these economies are on the path of self-sustaining growth. This is not evident so far.

Many experts have called for the withdrawal of the extraordinary measures taken in the past to support economies that were fast tumbling into recession. However,in our view,a premature withdrawal of these measures would increase the risk of a double-dip recession. From the sentiments point of view,this is one of the key risks to the Indian markets in 2010.

In India,while the economy is on the growth path,low credit growth has been a cause for worry as it has a bearing on private capital expenditure and hence on future industrial growth. Accelerating food inflation is another daunting challenge that the country faces. Besides causing hardships to the poor,it could lead to a decline in discretionary expenditure. From the fundamental point of view,this factor poses the second key risk to our markets.

Sentiments and fundamentals

Though the Indian economy remained largely insulated from the financial turmoil in the West and is slowly gathering growth momentum,our equity markets performance was largely dominated by global events and news flow. This was because foreign institutional investors (FIIs) have become one of the dominant forces in our markets. In future,too,global events and news flow will continue to impact sentiments and hence the short-term performance of the Indian equity markets. Our markets medium to long-term performance will,however,be driven primarily by fundamentals. We believe that the government and the monetary authorities in India and the Western world are not in a hurry to withdraw some of the measures they have taken in the past. But any change in fundamental factors has the potential to have a negative impact on the direction of our markets.

At 17,000,the Sensex is trading at 16 times one-year forward earnings,which is not terribly expensive. But neither are our markets cheap from the near-term perspective. Given their excessive focus on short-term news,markets tend to overshoot and undershoot fair valuation levels justifiable for long-term investments. India being a developing economy,we believe both the economys growth and Indian companies earnings will accelerate in the coming years. This will support the climb of equities to higher levels over the medium to long term. Hence,we suggest that investors invest in equities on the basis of the economys expected growth prospects while keeping in mind the principle of margin of safety. Only such an approach will enable them to create wealth over the long term. u

The author is chief executive officer,DBS Cholamandalam Mutual Fund