End of bull run or long-term bet?

VISION 2006 PART - III

Stocks have gained 37% in 2005 - third best in 15 years.

Will 2006 be another euphoric year for the markets? The consensus among stock market experts is that, while there is reason to be cautious in the short-run, medium-term prospects remain attractive.

But they also say that more important than the question of where stock prices are headed in the short-run is the qualitative change that has taken place in the market compared with the situation a year ago.

Caution is advised by many on account of the sharp rise in the Sensex over the past year. However, they add that the market shows no signs of runaway optimism or greed, which will point to over-heating.

Stocks have gained 37 per cent in value in 2005, the third best in the past 15 years. They have been driven up by $10 billion that have flowed in from foreign institutional investors.

Since the beginning of the rally in May 2003, the Sensex has more than tripled on the back of earnings growth of over 25 per cent per annum, mergers and acquisitions, healthier balance-sheets, better corporate governance, and improved regulations.

With this bull run, it is no surprise that experts are divided over the prospects for 2006. Raamdeo Agrawal, managing director, Motilal Oswal Securities, expects the market to move up to the 10,000-point level in 2006.

So has Merrill Lynch, despite recognising India as a not-so-attractive investment destination. It expects the market to be powered by net foreign flows of $5 billion. This excludes primary issuances.

In comparison, Kotak Securities pegs the Sensex fair-value band very broadly at 8,000 to 9,800, depending on the best and worst case scenarios.

Citigroup is positively bearish, and pegs the end 2006 Sensex target at 8,500, arguing that the market is overvalued today by about 30 per cent.

Nevertheless, most experts say that domestic investors are expected to commit more funds to the market as long as the party is not spoilt by a sudden shock. The mutual fund industry lent support to the market with purchases close to Rs 16,000 crore in 2005.

"Unless the market crashes, retail interest in equity mutual funds should rise," says J Rajagopalan, managing director, Bluechip Corporate Investment Centre, a leading fund distributor.

More importantly, though, foreign investors have bought the long-term story that India promises to be one of the world's fastest growing economies in the coming years, with a healthy corporate sector and well-regulated markets.

This has brought in a new class of foreign investors that now include not only momentum players and opportunistic hedge funds but the more stable pension and endowment funds, which are willing to stay invested for the long haul rather than focus on the vagaries of quarterly numbers.

This means greater diversity among foreign investors, lending a measure of stability to the market and reducing the risk of capital flight. In particular, there have been substantial flows from Japan, West Asia and Germany. Several new FII registrations have also come in from the Scandinavian countries like Denmark and Sweden.

India is part of a larger story enveloping other emerging markets. With doubts lingering about the sustainability of the US economic momentum "" given the macro-economic imbalances "" and US stocks sliding continuously, emerging markets are seen by many players as a good hedge against the US risk.

For this reason, foreign investors have poured substantial money into emerging markets, including India, despite the 13 interest rate hikes effected by the US Federal Reserve.

According to Massachusetts-based Emerging Portfolio Fund Research, net flows into the global, international and emerging markets equity funds that it tracks will surpass the $60-billion mark for the year, the second best year for flows into such funds since 1995.

Of the $7.1-billion inflow into Asian ex-Japan equity funds (country-dedicated funds), India equity funds alone have collected about $2.5 billion. In contrast, US and European funds recorded net outflows.

Will the flow into India continue? While there is good reason to believe that the India growth story remains attractive, stock valuations are high when compared with emerging markets. Competing markets like Brazil and Russia, for instance, look more attractive in terms of valuation, with similar growth dynamics.

"India figures among the most expensive markets in the world and unless economic reforms gather momentum, India as an investment destination looks less attractive from the global investors' point of view," says Andrew Holland, executive vice-president (research), DSP Merrill Lynch.

But then, markets often have scant regard for valuations when sentiments are positive. Stocks have gained from strength to strength even as several leading broking houses like Merrill Lynch, CLSA and UBS have been crying themselves hoarse about high valuations for several weeks.

India's price-earnings ratio stands at 17, compared with the emerging markets average of 12. But die-hard bulls say this is justified by the better quality of businesses in India.

Returns on equity for India Inc are at 24 per cent, compared with the emerging markets average of 16.

Anup Maheshwari, chief investment officer of HSBC Mutual Fund, refuses to fret over the high index levels. "Current valuations are close to historical average valuations. So, as long as there is earnings growth, stocks should take care of themselves," he says.