A P: Are we near the end?-II

India is one of only three markets in Asia where you can actually buy global industry leaders

I have received a lot of feedback on my initial article on this topic written on March 9. There seems to be also some misunderstanding as to what I was really trying to communicate in that piece.

Many people have taken that article to imply that we have reached a long-term top in the Indian markets, and that one should therefore, maybe, sell out of the markets and move on.

However, nothing could be further from the truth. My only intention was to point out danger signals clearly visible in both global markets and in India, indicating short-term over-exuberance, not to question the long-term case for India, in which I still believe very strongly.

Just for the sake of clarity let me reiterate my views, both on the short term as well the longer term.

I was (in the last article) simply trying to make the case that investor complacency seems very high globally.

The VIX (indicator of option volatility) was at an all- time low, emerging market bond spreads (EMBI+) also were at all-time lows and investors globally were searching for yield and higher returns, not mindful of the risks they were taking.

This search for yield and higher returns, and the desire to move up the risk curve were also manifest in the massive outperformance of mid-capitalisation stocks globally.

Jonathan Wilmot's risk appetite indicator moving into the euphoria territory was simply a more formal representation of all the anecdotal indicators described above.

The carry trade and strong global liquidity were causing many naïve investors to attempt to pick up yield and return by entering the (very often for the first time) emerging markets asset class.

The danger in this was that at the first signs of risk aversion increasing, these investors would pull back from the emerging markets, leading most likely to a significant sell-off.

This increase in risk aversion could be caused by some type of external shock or simply a tightening of global liquidity. My point was that if history is any guide, then within six months of the CSFB risk appetite indicator going into the euphoria zone (the case today), emerging markets normally sell off and thus we were in a sense on notice and should be prepared for some type of sharp sell-off.

My other related point was that in this emerging market sell-off (were it to happen), India would not be spared. India has now become a mainstream market, fully discovered by global investors with all the positives in terms of enhanced flows but all the downsides in terms of increased volatility and correlation with global financial flows.

The Indian markets also seemed to exhibit some signs of short-term over-exuberance (many anecdotal signs) and were thus ripe for a correction in any case, over and above the worrying outlook for emerging markets as a whole.

Be that as it may, the fact is that the Indian markets have now corrected by nearly 9 per cent (with mid-cap stocks and banks being hit particularly hard) from the time when the last article was written, and some of the complacency surrounding emerging markets, yield spreads, and global liquidity has dissipated.

As is normal, whenever the markets begin to decline (after a big rise), immediately people assume the worst and start calling for a much bigger decline. You will have enough people trying to panic investors into selling, by setting price targets for the index 15-20 per cent below current levels.

If they are right they can claim credit for having called the top; if wrong, no one will remember, and in any case they will have created trading activity.

My own sense is that we are probably near the end of this correction, maybe 3-5 per cent more, but the markets should then stabilise and consolidate. There is still a great deal of longer-term smart money waiting to enter India, and at lower levels the valuation support becomes quite strong and appealing.

I remain a great believer in the longer-term India story and feel that India remains one of the best bets for strong equity market returns over the coming decade. It is astonishing to me as to how many smart investors are now willing to commit long-term capital to India.

Institutions I consider as the real smart money globally are now willing to commit capital with three- to five-year lock-ups to India. These are not fools; these institutions have superb long-term investment records, and the fact that they are still getting in leaves me with great hope that the equity market story is nowhere near over.

The absence of any buying panic among the retail crowd and valuation still within the realm of reason only reinforce the above conclusion.

Ask these institutions what they see and they repeat the points we have been making over the last two years.

Over the coming decade, India should be able to grow at 7 per cent per annum (only China may grow faster), leading to a strong corporate earnings growth of at least 15 per cent.

Combine this with a strong entrepreneurial culture, decent corporate governance, and strong focus on profitability and returns, and most investors don't find the asking price of 12-13 times earnings too steep.

India is also one of only three markets in Asia where you can actually buy global industry leaders (others being Korea and Greater China).

Ask these same institutions if they don't feel they are late in coming to India. Don't they feel they have missed the boat,what with the markets almost doubling over the past two years? In reply, they all point to the experience of other markets in their discovery phase (e.g. Korea/Taiwan/Thailand), in each of which the rally was longer and of much greater amplitude than that seen to date in India.

They also point out that India is very under-represented in the MSCI indices. Its weight will increase on a secular basis and thus flows to the country will remain strong as institutions and the index itself continue to play catch-up.

There is also a very strong feeling that given the breadth and depth of the Indian markets, it will always be a favourite of the hedgies (most of whom are strongly overweight).

India is a stock pickers' market and always has been, thus providing strong scope for alpha generation. As the quantum of funds managed by the hedgies continues to grow exponentially, India benefits disproportionately.

It is not my intention to make short-term market calls; that is a mug's game with a very low probability of success. But I wish to re-emphasise that I remain a strong believer in the India story.

Some people have wrongly interpreted my last article as if I was calling for a market top and the end of the bull run. I was only calling attention to the high probability of a strong correction and frankly I now feel we are probably near the end of that as well.

I still feel we have a long way to go as far as this market is concerned. Let household financial savings into equities get back up to 5 per cent plus(where they were in 1994) from the current 1 per cent.

Then and only then will it be worth your while to worry about long-term market tops. Short-term corrections and volatility will be ever present but don't leave this party just yet, unless you have the instincts and reaction time to re-enter at short notice.