Last week, when the Sensex slipped to its lowest level so far this year, the mood in the market was despondent. The doomsayers were out on the street, predicting further weakness for the market indices. Most market observers were pretty sure that the Sensex would drop below the lows touched mid last year, when SEBI disclosed its discomfort about participatory notes in no uncertain terms and unveiled steps to curb their popularity among overseas investors. Some analysts, overcome by a sudden rush of extreme pessimism, predicted that the Sensex may slip to even 9000 before the end of this year.
After just two trading days this week, the mood is not so bleak any more. Strong gains in frontline stocks have helped the indices gain nearly 4 per cent from last week's lows and the Sensex is back above 15500. Some technical analysts are predicting another 20 per cent rise over the next few months, before a two-year long bear market sets in. The mainstream view is that the markets will go nowhere and the indices will linger around these levels, until the clouds clear and everyone has a better view of what exactly is going on.
Not many are convinced about the possibility of a bear market next year either. So, where are the markets headed? Will last week's despondency return soon or can investors expect better days ahead?
The Inflation scare
Inflation is now probably the most debated global issue now, way ahead of the US presidential elections, Iraq war and even 20-20 cricket. There is not a single central banker, from Ben Bernanke to Y V Reddy, who can sleep peacefully these days because a monster called inflation is at the door. If they don't slay the beast, their carefully constructed legacies will be blown to apart. Star central bankers will be unceremoniously degraded from divine infallibles to mere mortals, as Alan Greenspan recently found out.
There is a price you have to pay to fight a war and the war against inflation is no different. When a central banker gets ready for the fight, with the entire monetary arsenal at his disposal, he is also getting ready to cool the growth momentum. Being used to days of heady growth numbers, the loss of momentum can be very painful for investors.
Then the question becomes, to what extent will growth be sacrificed to tame inflation? That is not easy to answer as it depends on other factors which are not fully known. If inflation pressures are well entrenched, it will take strong and sustained monetary steps. The trouble is, a central bank will know how entrenched inflationary pressures are only as it goes along. And once inflation is brought under control, it will take considerable time for the economy to shake off the effects of monetary tightening.
That means a rather prolonged period of dullness in the economy, something the equity market is not very enthused about.
Crude on the boil
There is nothing that clouds the inflation outlook than record oil prices. Worse still, there is nothing central banks or governments can do about it. So far, governments have tried to contain the ill effects of record energy costs through higher subsidies. But, subsidies have now crossed the limits of sustainability and governments simply cannot afford them anymore without seriously damaging fiscal health. So, despite the political pressure, most countries have increased fuel prices.
The scarier part is that it is unlikely that oil prices will decline to acceptable levels anytime soon. True, acceptable levels are relative and have gone up substantially in recent years. The world will heave a sigh of relief if prices fall to even $100 per barrel, a price almost unthinkable even a few years back.
There are many, including the oil oracles at Wall Street firms, who predict oil prices will rise further – even touch $200 a barrel – before it declines. That no longer sounds incredible or improbable any more. The oil market demand-supply dynamics have proved to be much more inelastic than thought earlier. The incredible price surge has not cooled down demand appreciably or pushed up supplies, and both are unlikely even if prices rise some more. It will take a structural shift in the energy market – like new energy sources or ultra-efficient engine technology – to halt the price rise. Such breakthroughs don't happen easily and may be a long time coming.
The earnings decline
Rising commodity and interest costs will lead to higher overall costs and eventually lower consumer demand. This is already happening in most sectors. Auto sales growth has slipped, credit offtake has slowed and property prices are declining. Global uncertainties have clouded the environment for businesses that depend on external demand – like IT services.
Last quarter earnings reported by Indian companies showed a marked decline, when compared to the previous quarters. If the economic environment doesn't improve in the short term, the earnings are most likely to worsen in the coming quarters. And if this is the beginning of a prolonged period of slower growth for the Indian economy, especially given the political uncertainties that may unfold next year, it will be a while before earnings growth recovers.
The Chinese bubble burst
When the Shanghai Composite index crossed the 6000 mark last year and the market-wide earnings multiple for Chinese stocks was over 50, the Asia research head of a global investment bank wrote an article in The Financial Times, pooh-poohing fears of a Chinese stock market bubble and emphatically asserted that the rally would go on. The reason for his unrestrained optimism was very simple – the huge wall of domestic Chinese money waiting to flood the markets. The article even predicted that other stock markets too would benefit from this 'Chinese liquidity', when capital controls eased.
Those were the days when the phrase 'decoupling' was used more to explain emerging stock markets than broken marriages. There were many who predicted the Sensex to touch 40000 and the Shanghai Composite to jump past 20000, within a couple of years at the most.
The Shanghai Composite is now below 3000, having lost over 50 per cent from its highs. In comparison, the Sensex is down less than 30 per cent from its peak. That doesn't mean Indian stocks should fall further. The Chinese market was more obscenely valued last year and a bigger fall was warranted. Yet, such big falls in a marquee market like China depressed investor sentiment badly and the healing process may take a while.
It is possible that, if the economic picture improves, Chinese and other emerging market stocks may appear undervalued when compared to last year's levels. But, having gone through a lot of pain, investors may still be guarded.
When patience is indeed a virtue
None of these factors point to disasters around the corner. Not yet. It is just that the dark clouds over the economy now appear darker then earlier and it may take longer for the sky to clear. At the same time, we are also reassured that the economy – both domestic and global - is resilient enough to withstand even the worst shocks. Just a decade back, there is no way that the global economy would have survived the kind of credit crisis it is facing now. It should be a matter of great comfort for investors that 'the second worst financial crisis in history' has only shaved off barely a percentage point from global economic growth.
Still, equity markets may face a period of consolidation – or even an intermediate bear market – as the economy settles down before accelerating again. As always, investors with longer horizons will find enough opportunities in this market. Last heard, Warren Buffet was on a tour of Europe in search of companies to invest in. Even in his '80s, he continues to search for businesses that can deliver long-term value. No investor will do any harm by following the likes of Mr Buffet in these uncertain times.