Frontline Indian infotech stocks have shown great defensive strength versus the Nasdaq. Will this translate into outperformance in the event of a global bull run?
It's amazing how much of a difference two weeks of price rise can make where sentiment is concerned. All sorts of optimists have come out of the woodwork. Of course, if this rally is followed by two weeks of price decline, the sentiment might go bearish again.
Predicting long-term market movements can be just as difficult as trying to judge where the next hour's trading is going.
The next six months could be extremely unpredictable given that the global economy is in a fragile state and George Bush's aggressive postures in the Middle-East could lead to political turmoil.
However a few patterns and correlations seem to be emerging. The Indian IT sector remains correlated to the US Nasdaq 100, although there are differences in detail. These differences may work in favour of Indian IT stocks for reasons we will enumerate.
The universal reaction to a war in Iraq would be a panicky drop in market prices. But this might be an extremely temporary downmove and it could be a buying opportunity. The 1991 Gulf War for example, saw a 3-week downturn followed by a sustained bull run in both USA and India.
The September 2001 WTC incident also saw a sharp recovery after 2-3 weeks of hammering. In the latter case, the recovery was unsustainable because the US economy went into the doldrums. The last quarter numbers suggest that the US economy may finally be in recovery mode.
Another important factor is the stronger rupee. Big forex reserves are leading to a slow but steady strengthening of the rupee and that will eventually have an effect on investor perceptions. It will positively impact FII portfolio investments.
In macro-terms, a stronger rupee should lead to an increase in imports, a decline in export competitiveness and in the nominal value of exports. It could make Indian IT companies less competitive in low-end services like BPO. But it is difficult to factor these possibilities into current technical analysis. The trend hasn't been in force long enough to have impinged on stock traders.
The Indian market has been depressed since February 2000, when it started pulling back from highs in 6000 plus Sensex zone. The lows were hit in September-October 2001, at around Sensex 2000. That low has not been tested but neither has the market moved decisively up since.
The US Nasdaq fell much further after 9-11 hitting its latest lows only in late October 2002. By then it was some 20 per cent lower than the September 2001 levels. Even a sharp 35 per cent November rally has only just moved it back past 9-11 levels.
A cursory look at the index patterns suggests that there isn't much correlation between the Sensex and the Nasdaq. The Nasdaq reacted more from its highs, continued to react for much longer and has lately seen a sharper recovery. But Indian IT stocks have behaved in a fashion more akin to the Nasdaq. They reacted more than the general Indian market and recovered more sharply.
The more violent fluctuations of the Nasdaq have also masked the fact that generally the two markets and certainly the Indian IT industry and Nasdaq have moved in the same direction.
If one examines month to month movements in the Nasdaq-100 versus similar moves in Indian IT, the pattern is similar. The graph uses Infosys as a proxy for the Indian IT industry, and charts that against the Nasdaq-100 from January 2000.
The correlation between the two moves is as close as 0.94 over the last three years, which indicates a very high level of interdependence. Infosys is a market leader and it has seen less violent movements than many second-rank stocks.
The interesting thing is that Infosys has held its value far better through the last year. If one looks at movements since January 2002, the Nasdaq-Infosys correlation drops to just about 0.27, which is not very significant. In this 11-month period, the Nasdaq has dropped from 1934 to 1488, a loss of about 23 per cent, while Infosys has gained around 17 per cent.
Infosys's performance has been nearly replicated by other frontline IT stocks like Wipro and Satyam, which have both done very well (Wipro down 5 per cent, Satyam up 20 per cent) through 2002 in comparison with US tech stocks. However the bear market has also wiped out many second-rank IT stocks.
IT companies with suspicious fundamentals, non-transparent balancesheets and untrustworthy managements has been hit hard. The outperformers have all been companies that have held their own financially through the bad times. The purely speculative IT stocks have not moved up at all in the latest rally.
As far as FIIs are concerned, this makes the frontline Indian IT stocks an excellent defensive bet. Will this outperformance in adversity translate into a similar outperformance if the USA becomes bullish again? Apparently FIIs are betting that it will because Indian IT stocks have seen committed investments, at the sign of US recovery.
The stronger rupee could influence such investments positively. Portfolio investors have always had to reckon on the loss of value as the rupee declined from Rs 31 levels in 1992 to around the Rs 50 mark. That forex equation shows up in the dollar-denominated Defty dropping 42 per cent since February 2000, while the rupee-denominated Nifty has dropped 36 per cent. Over the next couple of years, the changed rupee-dollar equation might well lead to the opposite effect - the Defty gains more than the Nifty if the rupee strengthens.
The conclusions are not earthshatteringly original because they are easy to make. If the rupee continues to strengthen, frontline Indian IT stocks will continue to receive strong FII attention. That is, providing the US economy doesn't go into decline again and also that any Iraq war is fast and decisive.
In any sustained US rally, frontline Indian IT stocks will do extremely well. The intriguing question is whether they may also do well in the event of another US decline. The evidence of 2002 seems to suggest that this is possible.
