What next?

With the market swinging between unbridled optimism and violent corrections, investors need to take stock of their risk appetite.

Stock market investors are a confused lot. They undergo bouts of wild joy when they see the stock market scale greater heights pushing up the value of their investments. For the past three years, the stock market has risen about 300 per cent with intermittent corrections.

At every stage, investors have been worried on how far the rally would go further, and every correction has caused enough worries. The 922 point volatility in the Sensex in the past four trading sessions has jittered investors once again.

So what should an investor do: stay invested, invest more or sell? Are the Indian stock markets over-valued? Is there any upside left? Can the phenomenal rise in the stock market over the last three years sustain? Have all the good things come to an end? These are the questions that cloud the mind of every investor.

The rise and a little sputter
On December 9, 2005, the Sensex closed above the magical figure of 9000 points. The rally was fuelled by continued buying from foreign institutional investors (FIIs) with domestic investors betting on such buying to sustain the upward momentum.

The Sensex crossed the next 10000-points mark on February 7, 2006 in 41 trading days. Within the next 33 trading sessions the Sensex managed to touch the next milestone of 11000 points on March 27.

There were signs of the Sensex touching the next milestone of 12000 but after making a new intra-day high of 11930 points on April 7, it faltered.

Since then, though the stock market is going through a sell-off, which was triggered by a rumour that Sebi had banned 11 foreign institutional investors from the market. Even though the regulator denied the rumours, the Sensex fell 157 points on April 7.

On April 10, there was some recovery, but since then the market lost 425 points over the next two trading days. The fall in the stock market has been accompanied with huge bouts of volatility in the past few sessions, and daily swings of 400 points have become normal.

If FIIs have driven the rally so far, the decline too can be squarely blamed on them. They have been net sellers in the futures and options segment of the market for five consecutive days to the tune of Rs 8000 crore. In the cash market, they have turned net sellers for three successive days totalling Rs 1583 crore.

"India is expensive compared to other emerging markets. Also as interest rates in the US go up, FII investments in India could slow down or even go back to some extent," said IV Subramaniam, senior fund manager, Quantum Mutual Fund.

Bullish for the long term
Though the huge bouts of volatility must have given the chills to many short-term investors, long-term investors need not worry. This is what most industry experts are saying.

"My view on the market is bullish on the long term and cautious in the short term," says Nilesh Shah, chief investment officer, Prudential ICICI Mutual Fund. India's growth story remains intact as the India's economy growth rate of 8 per cent plus makes it one of the fastest growing economies in the world.

Though some FIIs have withdrawn money from the Indian markets, analysts are generally positive on FII inflows going forward. FIIs invested over $10 billion during 2005 and have poured in close to $4 billion in the first quarter of 2006.

"The Indian economy will continue to do well and the stock markets will also perform well and continue to attract foreign investors," says Vinay Kulkarni, Senior Fund manager Equities, Deutsche AMC.

Market gossip suggests that there is still a lot of FII money sitting on the sidelines, and will enter on dips. Plus, the domestic mutual funds, which too are sitting on large cash piles, could bring some support to a falling market.

Short-term woes
But that does not mean we have seen the end of the fall. Several brokerage firms of the likes of Merrill Lynch, JM Morgan Stanley and Citigroup have cautioned investors of stock markets being expensive for the past few months, while the market has only gone up.

With the decline last week, may be we could see the correction extend further. One analyst who does not wish to be quoted says, "A small correction in an over-heated market is healthy, as a sharp fall later could prove detrimental for all investors."

Nilesh Shah, chief investment officer of Kotak Mutual Fund, says, "I would not be surprised by a 1000 to 1500 point correction after the run-up we have had, but India is like a growth stock, and you cannot compare it with other nearby markets using the same scale."

What can go wrong further?
Among the India bears, Societe Generale and Dresdner Kleinwort Wasserstein (DrKW) have been the most vociferous. Societe Generale said in a January report that the Indian market has the characteristics of a bubble based on the P/E multiple, while DrKW's Albert Edwards said India's equity valuations were similar to Thailand's before its economy tumbled in 1997.

A 1,500 point fall from the top will bring us to a Sensex level of 10,500 points, which is not so low. But can the markets fall any further? For that to happen, net FII outflows would need to be in the order of $2 billion-plus, or corporate earnings to start slowing down significantly.

If the 10-year US treasury starts yielding 6 per cent levels from the current 5 per cent, there could be a change in investor opinion on emerging markets with FIIs finding the Indian P/E multiples expensive.

But a 1000-1500 point correction and even a slower earnings growth in the March 2006 quarter should bring the market P/E multiple at more palatable levels. So, the chances of markets correcting 20 per cent from the highs may not be so strong.

What should an investor do?
The first thing investors need to do is figure out their risk appetite and check if they are over-invested in equities. The risk-averse could move a small portion of their investments into cash. With the flourishing derivatives markets, investors could hedge their investments by using futures and options on the index too.

Being invested in defensive sectors like FMCG and pharma has often been the panacea to a market fall in the past. But that may not work this time so well as KR Choksey's director Jigar Shah says, "It is not necessary to move to defensive sectors as the valuations there are not defensive. It is better to be well diversified."

Prudential ICICI's Shah suggests that investors go back to basics and follow a bottom-up approach to investing. "One should focus more on individual companies than sectors. It is difficult to chase sectors and markets as markets keep going up and down. So you should not concentrate on any particular sector, but your portfolio should be well diversified. If the company is good then the stock will perform well."

In the eventuality of a market correction, it is better to stay invested in large-caps than in mid-caps or small-caps. "Large-cap stocks would be dominant in the near term because there is a sense of flight to safety," says Rajat Jain, chief investment officer, Principal PNB Mutual Fund.

There is some safety in seeking professional help too. "At these market levels it is better to invest by taking expert advice as the hit and miss approach can be costly," says KR Choksey's Shah.

Jain agrees: "At these levels, I would recommend investors to invest through the mutual fund route rather than investing directly as the market is extremely choppy and volatile and it will remain so over a one year period."

Investors who have the confidence to commit funds at current levels will be better off through the systematic investment route.

Abhay Aima, country head, equity and private banking group, HDFC Bank, has an interesting advice: "In the current market, investments should be made through the systematic investment route, both in equities and equity funds, and if investors can commit a fixed sum at regular frequencies, is the best way to beat volatility."

He suggests that instead of investing once a month, if investors could do it once a week, they would capture the better part of the volatility.

Over the past three years, systematic investment plans have earned less returns than investing in lump sum as the market has mostly gone up in a linear fashion. But with current valuations, systematic investment plans are likely to work better than one-time investments.