Imminent market correction expected

Every time the Indian stock market goes up, there is an eager tribe of market pundits willing to talk it down.

So, the current debate is whether the benchmark index of the Bombay Stock Exchange will correct by 10 per cent to 16,000 before zooming to 21,000 by the end of the year.

Some see an imminent correction, despite a smart recovery last week, and here's why.

After record foreign inflows of $29 billion in 2010, foreign institutional investors have hit pause, resulting in a withdrawal of $1.7 billion from the market earlier this year. This brought indices down.

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Concern about inflation, corruption, high interest rates and rising commodity prices fed the bearishness.

In the subsequent two months, nothing has changed for India. If corruption and macro-economic threats persist, so does the country's long-term growth story.

Quarter after quarter, the central banker continues to battle inflation with rate hikes, and corporate India strives to get a grip on profitability as raw material costs mount.

Some analysts expect weak fourth quarter results, with input cost pressures mounting to an extent that earnings growth will tail off quite significantly.

These are valid concerns, but the good news is that a majority of market pundits think otherwise.

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The overriding view is that the recovery in the markets has been on the back of a surge in consumption demand, which has remained high in spite of high inflation.

And that is not going to change in a hurry. Besides, the market is now reasonably valued at about 15 times, which is more or less in line with earnings growth expectations for FY12.

This is specially so when the global environment remains uncertain. The majority view also is that the market has already priced in some oil price rise due to the tension in West Asia, a tight monetary policy stance for some time and the expected less-than-satisfactory Q4 results.

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Interestingly, over the past 12 months, investors have been rewarding stocks of companies with low capex, rising institutional ownership, stocks with inexpensive valuations and trailing monthly performance. In contrast, low free cash flow companies have been losing out.

The underlying mood remains bullish. Only a weak monsoon would dampen these sentiments.

In the midst of all this bullishness, there is, however, one emerging area of concern. Over the last one year, it seems the FII interest in index options has substantially increased.

Looking at the volumes on NSE, it is evident that nothing significant is happening in the cash markets as all the action is concentrated on the index options side.

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Week after week, the volumes on the options side are increasing, which is what pushed Nifty past the 5,600 mark last week.

Clearly, investors are shorting the market and little money seems to be going into delivery stocks or even stock futures.

Some view this as a dangerous trend since foreign investors, who are market makers for Indian equities, seem to be punting on the index and not taking a long-term view investing in equities.

That's a risk investors should be aware of.