If New York sneezes...

The market's leading indices may not yet have fallen below the lows of September 2007, but many analysts now reckon that a bear market has technically set in "" because the indices have closed below the 200-day moving average on three consecutive days. Analysts who were bullish when the Sensex was at 21,000 are now bearish when the index has dropped to 16,000. Realistically speaking, momentum buying should give way to value buying at the lower equity prices that now prevail; but for all one knows, the new phase could be momentum selling as the market over-corrects "" as it is wont to do. Considering that there is trouble in multiple markets (mortgages, equities, credit, currencies, jobs), it is hard to forecast how things will work out when there are mutually reinforcing problems. What is clear is that there is heightened nervousness all round, as to what is to come next.

Still, even though the Sensex has dropped by 23 per cent from its peak level two months ago, and though the market plunged through last week, the Indian market has outperformed emerging market equities over the past year. However, that cannot hide the fact that much has changed since September; above all, the sub-prime crisis in the US has got much worse than initially predicted, and US housing prices have dropped to levels where foreclosures will continue to climb. Credit spreads have widened, and a US recession is of course now taken for granted. The de-coupling theory may or may not be valid when it comes to over-all economic trends, but it is manifestly non-operational when it comes to financial markets. If stocks fall in New York one day, they will almost certainly fall in Mumbai the next. After all, foreign institutional investors have been compelled to take home some profits even if they believe that India remains one of the world's better investment destinations.

While the froth created by large speculative positions in the options and futures segment may have come off, both high net worth and retail investors will take a while before they come to terms with their losses. The so-called strength of domestic liquidity is not in evidence, though it would be unfair to expect mutual funds and insurance firms to buy into the market in its current condition. Volumes in the cash market are therefore about 40 per cent lower than the peak, and headed towards the lows of mid-2006. At 15,976, the Sensex trades at about 16 times forward earnings, which is reasonable in the Indian context. But investors are not convinced that all risks are priced in. They may well be right, because there could be an earnings downside that has not been anticipated.

Meanwhile, most observers are convinced that the growth in corporate earnings, even if it tapers off, should be reasonably good, in the 15-20 per cent range. But that does not seem to be good enough for investors, and it's not that their concerns are unfounded. The financial problems of banks abroad could worsen, and not all of them may be bailed out by sovereign funds. Technology firms are vulnerable to falling orders and banks are already taking hits on exposures overseas. The farm loan waiver, without a clarification on how banks will be compensated, has added to the uncertainty. It would help if the Reserve Bank dropped interest rates, but that is not certain when inflation is going up.