Spring on Dalal Street

Does the stock market rise reflect a real economic upturn?

In the last five weeks, Indian stock markets have seen a spectacular recovery. The indices have swung up over 15 per cent. This rise has been driven by a shift in the attitudes of foreign institutional investors (FIIs), who have, since January 1, 2012, bought a net $3.4 billion of Indian stocks (and put a slightly larger amount into rupee debt). In contrast, domestic institutional investors have been net sellers. The forex inflow has also pushed the rupee up by eight or nine per cent against most hard currencies. There has been little apparent change in geopolitical dynamics or global economic indicators to justify this turnaround. The Greek debt crisis remains a big question mark; worries persist about contagion and larger euro zone nations have seen downgrades. Tensions persist in West Asia and Iran, causing upward pressure on energy prices. Closer to home, India has scaled down the gross domestic product estimates for 2011-12 and the third-quarter results have seen earnings growth impeded by the persistence of high inflation and rising interest costs. So why the change in sentiment?

The answer lies perhaps in the fact that many FIIs begin their fiscal years in January and revise countrywide allocations at that time. India seems to have received higher weighting in most 2012 portfolios, because it promises both higher growth and more stability compared to Europe. The Nifty has climbed above its own 200-day moving average, which means that it is doing better than it has during the previous 10 months. Trend analysts consider this a powerful lagging indicator of bullish sentiment — entirely absent in 2011 when the Nifty was among the worst global performers, losing over 22 per cent.

Is this rise a flash in the pan or a sustainable trend reversal? The answer is important, and not just to traders. The wealth effect that arises from capital gains can trigger higher consumption demand. A buoyant secondary market also translates into an active primary market, which makes it easier to raise cash. Better primary sentiment could also help revive moribund disinvestment plans. Assuming nothing dramatic occurs in West Asia, Iran, or Europe, domestic investors seem focused on two near-term events: Assembly elections and the Budget. If the Assembly elections go well for the Congress, that gives the United Progressive Alliance some leverage to carry out long-awaited policy actions, despite fractious allies and crippling scams. Following from that, the Budget may help to stimulate animal spirits. Or it may not. Despite the FII switcheroo, domestic investors are likely to remain cautious until those outcomes are known. In valuation terms, it’s difficult to justify the Nifty trading at a current price-equity ratio of 19-plus on the grounds of current interest rates or near-term earnings estimates. But equity investors always make calls on what they think the future holds, rather than on current or past performance. If the market consensus is that 2012-13 will indeed be better than 2011-12, the stock market’s U-turn could be a harbinger of change in the real economy.