Higher rates will choke realty, cyclicals

MARKET INSIGHT

After the three-year bull run, the market is gearing up for an imminent correction.

In mid-2003, the Nifty was trading around the 1000 mark. Since then, it has risen nearly 300 per cent in three-and-a-half year of a bull run interspersed with the occasional sharp correction. India has never seen a bull run sustained over such a long period.

In 2006, the momentum showed little apparent signs of a slowdown. There was a big correction in May-June. But the recovery took the market to new highs.

Over the year, the Nifty has moved up by 50 per cent, the Sensex climbed into five-figures and rose by 47 percent. The CNX midcap rose 27 per cent and the BSE smallcap was up 14.5 per cent.

In addition, some 70-odd IPOs raised over Rs 20,000 crore and Indian investors parked another Rs 35,000 crore in assorted mutual funds.

Foreign institutional investors invested a net Rs 37,000 crore over the calendar year, while Indian funds invested over Rs 20,000 crore in the financial year starting April 2006.

So, on the surface, everything is rosy. Digging slightly deeper, we can say that the run was driven by excellent corporate performance, which in turn was driven by excellent GDP growth.

Even at exalted levels with Nifty flirting with the 4,000 mark, the current PE is just over 21, which is fine, given that average earnings per share growth is comfortably higher.

The rise was also well-distributed as well with companies from almost every industry group responding to pleasant conditions. Obviously, big stocks responded more as a group - that is natural because institutional investors concentrated on these counters. So, can we expect an encore in 2007?

It's when we look at several apparently unrelated factors that doubt arises about sustainability of prices at these levels.

First of all, the bull run is built around a wave of consumerism that was sparked off by higher salaries, lower interest rates and lower inflation - a combination that first occurred in 2003-04. In particular, the housing and auto boom are driven by cheap retail loans.

Rates have risen slowly through 2005-06 and they are almost guaranteed to rise further. The RBI's advisories make it clear that the central bank is worried about overheating and inflation.

At some stage, higher rates will act as a choke on real estate and other cyclicals and that will lead to a pullback. A PE of 21 implies a yield of about 5 per cent and that is low in a scenario, where the 364-Day T-Bill yield is around 6.7 per cent.

Second, GDP growth in Eurozone, Japan and above all, the US, is losing momentum. At some stage, that could mean a flight of FI capital.

The May-June crash was provoked by gyrations in the dollar and global commodities; the December correction was provoked by currency controls on the Baht. Like it or not, India's stock markets are as sensitive to the Fed's manoeuvres and other external factors as to the RBI's moves.

Third, the Indian economy itself may slow down. It's already operating at well above normal capacity utilisation and there is simply not enough slack to feed new demand.

Investor expectations are now unrealistic - people have seen three years of 25 per cent plus earnings growth. Thus, one flat quarter could lead to a big correction.

Due to these factors, 2007 may prove to be disappointing for the blindly optimistic bulls. If there's a correction, how deep could it get? In fundamental terms, if the secure debt yield is in the region of 7-8 percent, a PE ratio of 12-15 is sustainable.

If we're thinking in terms of PE to earnings growth, the PE ratio could be on the higher side. We could see a 25-35 per cent correction through 2007, if people start thinking in these terms.

On the plus side, crude prices do seem to be settling down. At some stage, all the infrastructure creation should translate into more economic opportunity. And, if the real estate market continues to deliver, there will be a wealth effect that keeps the pot boiling. Real estate and related stocks (construction, cement,) are the pivotal areas.

A slowdown in these will affect everyone. If you are an optimist, you would stay invested across these areas even after the astounding returns of 2006.