A pause button

The sharp correction in stock prices on Wednesday has been followed immediately by a correction of the correction. Stock prices have thus repeated the trend of recent months: every correction merely becomes opportunity for more buying. Indeed, now that the market has gained almost 40 per cent in slightly more than four months, it should be a matter of reassurance if there is the occasional correction, and if profit-booking takes place even as fresh money comes in""as seems to be happening. The question to ask is whether investors should begin to get skittish at today's stretched stock prices.

At centre stage in Wednesday's fall was the unwinding of an unusually large $359 million position by foreign institutional investors (FIIs) in the derivatives segment. While some of the sales can be attributed to plain profit-taking, what spooked the FIIs is the rise in interest rates all over the world. The yield on 10-year US treasury bonds had gone up by 19 basis points in just four days, to 4.74 per cent, as the market started worrying about a change in the US Federal Reserve's stance on interest rates. For the past three months, there were signs that the Fed would stop hiking interest rates, but with the US economy going strong, there were hints that the Fed would raise rates again to control inflation, as the economy continues to remain strong. The same is the case with the European Union.

Flows in emerging markets are susceptible to US interest rates, as everyone knows. If the Fed rate goes up beyond 5 per cent, as some analysts expect, the 10-year US treasury could well touch 5.5 per cent and even 6 per cent. With that kind of a return from one of the safest instruments in the world, some money will prefer the safe haven to emerging markets, some of which are clearly over-valued. And there is no doubt that the Indian stock market, like other emerging markets, has been propped up by huge inflows of FII funds. In the first nine weeks of 2006, FIIs have invested something like $3 billion in the cash market. This signals that the flow is expanding, not contracting, for it compares with the $10.8 billion and $7.7 billion that came in during the full years of 2005 and 2004, respectively. But what if interest rates rise further?

If money keeps flowing in, it can only be because India's fundamental story remains attractive. Net of the banking and refinery sectors, corporate sales of 2,645 companies increased 14.85 per cent, operating profits rose 15.76 per cent and net profit 24.31 per cent in the December 2005 quarter, over the corresponding period a year earlier. GDP grew at 8.1 per cent, and India remains one of the fastest-growing economies of the world. The Budget meanwhile has given positive signals and renewed everyone's faith in fiscal discipline.

But the macro numbers must yield at this stage of the bull run to the price and value equation in the market. On a trailing 12-month basis, the Sensex traded at a P/E of almost 20 at its highest close of 10,735 points on Monday. This P/E multiple is high on a historical basis, but markets have traded at high multiples in the past. Several brokers, including JM Morgan Stanley and Citigroup, have cautioned investors on Indian stock markets for the past few months, and even the relatively bullish JP Morgan said recently that India could get less flow than other emerging markets due to its higher value levels. But, surely, there are investors out there regretting their sell decisions of recent months. Market players say that there is still a lot of money waiting on the sidelines, and therefore there may be good reason to expect fresh inflows in the case of a correction. Beyond that, the key to the future lies with the Fed.