September 2010: Exuberance ahead of reality

After almost a year of trading in a narrow range, equity markets in India jumped up sharply this month and it currently trades slightly short of its all time highs. Equity markets were up over 10% for the month, and such strong double digit performance in a month is a rarity. The strength in the markets were mainly led by strength in global equity markets, and the increasing belief that the double dip recession is unlikely to occur for the global economy. The market up move has also been triggered by a short covering rally and several skeptics having to change their opinion.

Global investors continue to infuse large sums of money into the Indian equity markets. Inflows by FIIs in September is amongst the highest seen by foreign investors in any month. Domestic Mutual Funds, in the same period, continue to be sellers. A large part of the incremental money coming into the country is being absorbed by IPOs and private placements by companies, but the rush of capital is large and the quality of equity raising is starting to decrease. Typically, such behavior is seen in bull market peaks. Over the rest of the year, there will also be some very large government company IPOs, leading to additional absorption of capital.

Though 2 ½ years has passed since the previous market peak, revenue growth for several companies has come off since 2007-08. Moreover, one is seeing increased pressure on margins, and therefore earnings growth for companies is under pressure. After the earnings releases of June quarter, the SENSEX earnings published by BSE show that earnings have barely budged, whereas the market participants are expecting earnings growth for the year March 2011 to be between 25-30%. The level of optimism surrounding business is far lower than what one witnessed in 2007-08. The potential of the Indian economy, as seen by foreign investors is far ahead of the perception within India. The lack of buying by local investors and continuing selling of equity by promoters, whereas large scale investments by foreigners indicates this perception gap. We believe this is due to weak opportunities for investment in developed markets, rather than attractiveness of the Indian markets. As a result, Indian markets continue to be expensive, triggered by external capital.

Several of the core holdings in the portfolio have been doing well, but trading at the top-end of their valuation range. We may see a bit of a correction in the short run in some of these positions. The portfolio is also positioned to take advantage of any correction, but is likely to under perform if markets move up sharply from current levels. We continue to remain cautious, as the level of exuberance seen in equity markets is ahead of reality. Normally, such exuberance corrects itself, but it is difficult to predict how long it would take for a major change in perception.