US may spoil Dalal St party

The current rally could be tested when the US 10-year treasury yield rises above 4.5%, making emerging markets less attractive.

With the BSE Sensex rising over 56 per cent from its yearly low of 5022 (August 23, 2004), on top of substantial gains recorded the year before, investors must be wondering whether the party will go on.

"If the Indian economic numbers remain robust and continue to show a growth above 7 per cent, complemented by export driven story from steel, pharmaceuticals, software and auto components, then there will be a strong support to market sentiments in the months to come," Firstcall India Equity Research's (FIER) said in its latest report.

The liquidity, which has driven Asian markets, including India, to multi-year highs has been found to come from three sources: macro hedge funds, which have unwound their long, yen trades and shifted the funds into equities; equity hedge funds increasing their leverage; and an influx of US-derived money into international funds.

The cause for concern is the last of the three sources, which is attributed to the $15 trillion coming out of the so-called US property rally.

This liquidity had been created as to property owners are borrowing money against an inflated value of their property and spending the same.

The increase in leverage in the western financial system has resulted in more money flows into emerging markets as investors looked to diversify.

However, logically as long as the US property market stays inflated, money will still be flowing into emerging markets, sustaining the gains, the report said.

However, Asian markets including India, is experiencing high valuations and excess liquidity. The current rally could be tested when the US 10-year treasury yield rises above 4.5 per cent, which will make emerging market investments seem less attractive. Last week, the 10-year yield added nine basis points to 4.28 per cent.

Meanwhile, the gains posted by Indian stocks over the past two years were entirely driven by earnings, as opposed to a re-rating based on multiples. Earnings-driven rallies typically rise and fall based on the health of the economy, and not on long-term rates.

If there is good news, it is that earnings-driven bull markets tend to last 1.5 times as long as re-rating (PE-driven) rallies, said VVLN Sastry of Firstcall India Equity Advisors who prepared the report.

The bad news, however, is that the current rally has already lasted 2.5 years and further market rise will come only with a lot of "ifs and buts".

High growth rates shown by the corporates cannot be sustained in the longer term due to paucity of capacities and other structural reasons, the report said.

History also suggests that 60 per cent of earnings-led bull markets have ended with a recession.

Besides, the inflation factor, which is kept low at the cost of Rs 40,000 crore losses to the country's oil economy may prove to be a dampener in the long run.

Any decision to pass on the international oil price rise to the customers to make good the losses the PSUs are incurring, may affect corporate profits in the form of increased input costs.