Foreign inflows hold the key

In the past as well, the correlation between FII flows and benchmark indices has been high

A sharp correction in the stock market since the beginning of 2016 has sparked off a debate about a bear market on Dalal Street. Technically, a stock market enters its bear phase when multiple benchmark indices decline by 20 per cent from the highs on a closing basis for at least two months. For one day last week, the Sensex closed 20.1 per cent lower at 23,962 from its all-time high in February last year. Stock prices have since recovered and the Sensex is now down only 18 per cent from the high. While we are not in a bear market yet, some analysts, however, do warn of further downside given poor corporate earnings in the third quarter and continued weakness in the global economy.

SENSEX MOVEMENTS, BEAR MARKETS OF THE PAST AND WHERE WE STAND CURRENTLY

Saurabh Mukherjea, chief executive officer (institutional equities), Ambit Capital, expects the benchmark Sensex to bottom out at around 22,000, translating into a further 10 per cent slide from current levels. Dhananjay Sinha, head, institutional equity, Emkay Global Financial Services, is even more conservative and expects the Sensex to go below 20,000 points at 12 times trailing earnings per share.

The broader economy has, however, entered a bear phase long ago. The non-financial companies have reported negative profit growth in three out of the last four years - the longest streak of declining corporate earnings since 1991. The analysis is based on the finances for BS 1000 companies, the annual list of the country's 1000 biggest non-financial firms ranked by revenues.

In all, BS 1000 companies reported negative profit growth on seven occasions in the last 25 years, three of them in the last four years. In FY15, the combined net profit of BS 1000 companies was down 12.1 per cent.

STOCKS THAT DID WELL DESPITE A MARKET FALL

The markets and the economy have faced a similar challenge in late 1990s. Then, BS 1000 companies had reported negative profit growth on three occasions between FY97 and FY02. Experts, however, say that the latest occurrence is unique in many respects. "The stress was only in the cyclical and investment-related sectors at that time, and companies in fast moving consumer goods, pharma and information technology sectors had bucked the slowdown. The slowdown is now across the board and may take some time to resolve," says G Chokkalingam founder & CEO, Equinomics Research & Advisory.

The deflation scare is also a first for corporate India. "For the first time in over 25 years India's GDP at nominal prices is growing at a slower pace than that at constant prices owing to price deflation. As corporate revenues and profitability grow in proportion with nominal GDP, it has worsened corporate profitability and made debt servicing tough for many companies," says Nitin Jain, president & CEO, global asset and wealth management, Edelweiss Capital. At the end of FY15, India's top companies by revenues were sitting on all-time high debt of Rs 31.6 lakh crore, equivalent to 52 per cent of their combined revenues and 27.3 per cent of the country's GDP at nominal prices last year.

Stock markets were largely spared the bad news in the corporate sector thanks to strong inflows from foreign institutional investors (FIIs). Foreign investors stepped up their exposure to India after a brief sell-off in the first half of 2013 triggering a bull run on the Street. They were proved right initially as corporate profit growth turned positive in FY14 after two years of decline.

Domestic investors followed FIIs pushing valuations to record highs. In March 2015, the top 1,000 companies were collectively trading at all-time high price-to-earnings multiple of 29 times their FY15 earnings. The index peaked in the March 2015 quarter. The latest correction was in a sense long overdue, say analysts.

Analysts say that liquidity (capital flows) is playing a bigger role in markets than underlying corporate and economic fundamentals. "The markets are now largely about liquidity flows. If flows are benign then stock prices will rise regardless of the underlying fundamentals at least in the short to medium term," says Emkay's Sinha.

This is borne out by historically strong correlation between the movement in the BSE Sensex and the FII inflows in India. The current market downturn as all the others in the past have been triggered by a sell-off by FIIs.

Analysts expect FII inflows into India to remain soft in the near to mid-term given the rising risk aversion to emerging markets and the risk-reward ratio moving in favour of developed markets. "FII inflows in secondary markets could remain weak for some time given growth risks in emerging markets and improvement in the growth outlook of developed countries especially the US," adds Edelweiss' Jain.

On the other hand, a bear run in the benchmark indices doesn't translate into a static market. The Indian market is one of the most diversified markets in the world and many stocks and sectors could buck the trend and give positive returns as seen during the previous market declines.

Stocks that could defy a bear hug would be market leaders from defensive sectors such as FMCG, pharma and IT. Stocks such as Asian Paints, Dr Reddy's, GlaxoSmithKline Pharma, Hindustan Unilever and Tata Global Beverages have done well in past downturns.

Another group of stocks could be those with reasonable valuations with zero or negligible debt on their books and strong cash flows. Software services stocks such as Infosys, Tata Consultancy Services, Wipro and HCL Technologies could fit the bill here.

"In bull markets you look for growth opportunity; in bear market, stock selection is all about minimising downside risk," advises Sinha.