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Why the bull run could turn in 2006

Sulagna Chakravarty | January 03, 2006

The last year was really great for investors, with the Sensex giving returns of over 40%. It was the third straight year of double-digit growth for the stock market.

Everybody made money.

Which brings us to the question: Could the bull market turn this year? Here are some factors that could determine its course.

Foreign Institutional Investors

The very first reason why the bull run could slow down is that FII inflows, which have propelled the market up all through this three-year rally, may slow down.

That may happen for two reasons.

1. Flows to all emerging markets may slow, and with that flows to India may automatically be reduced.

This scenario has been predicted for a long time. Pessimists keep saying that as interest rates in the US rise, the money will flow back to the US. Because now the FIIs will get a higher return with higher interest rates.

The US Federal Reserve (the US central bank like India's Reserve Bank) raised its Fed Funds rate (the rate at which it lends to other banks) from 1% to 4.25% in a series of rate hikes. Yet, flows to emerging markets have remained robust.

But, it's widely expected that the US Fed will soon stop its series of hikes. So flows to emerging markets should continue.

2. Flows to emerging markets may continue but flows to India may slow.

This may well happen.

As of now, the Indian stock market is one of the most expensive emerging markets, with a PE ratio much higher than for other markets. Let me explain.

Earnings Per Share = net profit/ number of shares
Price Earnings ratio = market price/ EPS

The PE ratio of the Sensex is around 17. This means if we add up the price of all the 30 Sensex companies and divide it by their EPS, the result would be 17.

Foreign investors may therefore prefer to put their money into relatively cheaper markets like Korea. Because, they will tend to make higher profits as the stock markets there rise. In fact, a Merrill Lynch survey of international fund managers found that most were underweight (less money allocated) on India.

The bottomline is that almost everything depends on how high global liquidity (money flow) is.

At the moment, lots of FII money continues to come to India. Part of that is Japanese money and part is money from the Middle East countries, which have grown fat on oil profits.

But Japan is slowly reviving, and new money may be pumped in there rather than in emerging markets.

Combine that with the fact that the Indian market is expensive, and your return on stocks could be much lower this year.

Oil prices

Higher oil prices could be a real dampener. If oil prices rise to around $70 a barrel, that could spell trouble for a lot of economies, especially energy-importers like India.

The Merrill survey pointed out that fund managers believe that stocks will be affected only in the price goes above $69 a barrel. The market will take anything lower in its stride.

But since the growth rates in the Indian and Chinese economy show no sign of slowing down, it's quite possible that oil prices may go higher.

If they do, the US Fed may also be tempted to increase interest rates further. As mentioned above, this could have a dampening effect on money flowing to emerging markets.

Corporate earnings

Almost all analysts predict that corporate earnings in India are going to slow down.

1. It's difficult to keep up the growth tempo when the base is getting higher.

2. Almost all companies have reached the limits of their production capacity, which means that top line growth could slow till new capacity comes on stream.

3. Demand for credit (money in the form of loans) has been rising exponentially, and could result in higher interest rates.

4. Commodity prices could shoot through the roof, fuelled by rising demand from China. That could hurt companies that use these commodities.

Analysts, however, don't seem to have factored in the fact that mergers and acquisitions may lead to higher earnings growth. Also, higher rural demand, the result of the excellent rabi crop, could also boost growth for some companies.

Nevertheless, the risk remains.

Rupee depreciation

During the last two years, the rupee had been appreciating against the dollar.

Suppose the FII put in money into the Indian stock market. And, the rupee appreciates by 5% in a year. That means, at the time of converting his rupees back into dollars, every rupee would earn more dollars.

If the stock the FII invested in provided him a return of 15%, his total return would be 20% (15% + 5%). No wonder foreigners were eager to put their funds into India.

Now, however, with a depreciating rupee, the time of converting his money back into dollars, he would have to pay more rupees to buy dollars.

So, if his stocks earn him a 15% return and the rupee depreciates by 5% per year, his return at the end of the year will be 10% (15% - 5%).

US scenario

And finally, the doomsday scenario.

Much of US growth has been the result of the boom in housing there. If that were to end, US growth may slow and consumers there would start cutting back their purchases.

This means that Asian nations will be able to sell less to them, and growth in Asia too will slow.

Further, that will mean that Asian countries, which till now have invested their surpluses in the US, will have lower surpluses to invest.

That will mean higher interest rates in the US, which again will hurt US growth and consumption.

The effect: stocks falling out of favour all over the world.

Thankfully, the central banks are not going to sit by idly while all this happens.

So let's just wait and watch.

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Number of User Comments: 2

Sub: real dumb

i agree.. author has messed up everything.. poor writting.. plz improve.

Posted by A B Baby

Sub: Who the hell is the author of this!!

Who the hell has written this circle article. Writer makes a statement and the turn it around and not even clear whether it is a ...

Posted by Manoj


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