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Markets: Follow the fundamentals!

After a tumultuous 2004 that saw the Indian stock markets crash from their historically high levels (mid-May) only to create history as the year moved towards its close, there has been growing apprehension in investors' minds whether this rally would continue into 2005.

Before moving any further, let us take a note of key reasons that led to the rally in 2004 and the factors that might determine the fate of the same in 2005.

Liquidity was one of the biggest factors helping the markets to sustain high levels of a considerable period of time in 2005. This liquidity was spurred by huge FII inflows that followed the Indian growth story. The depreciation of the US dollar against the rupee under pressure from a huge US current account deficit played a major role in this depreciation of the dollar. One might wonder that, as against expectations that the rise in US interest rates will lead to FIIs diverting their money back to the relatively safer US T-bills and bonds, nothing of that sort has actually happened.

What more, FII activity has heightened during the second half of the year. One important reason for this is the fact that despite the rise in US federal funds' rates (2% currently), the real interest rate (adjusted for inflation of around 4%) is still a negative 2%. This means that it is still beneficial for US investors to borrow at negative rates and invest in attractive emerging market equities and debt.

Now, the looming danger of rising inflation in the US economy spurred by a slide in the value of the dollar might, thus, be an important factor that Indian investors need to keep in mind. Fears of inflation rising out of proportion might lead to the Fed raising interest rates 'faster than anticipated'. And this might then lead to the much-touted FII inflows to reverse their flow towards the US.

Now, apart from this big 'negative' there are some (positive) factors that are likely to continue to help the cause of Indian markets in 2005. Key amongst these are -

1. The reform orientation of the incumbent government

2. Strong credit-offtake from the non-farm sector

3. Improving 'measurable' risk-taking capacity of India Inc.

4. Lowering of trade barriers across nations

5. Rising internal demand for goods and services

All in all, while 2005 might witness a continuation of the trend that was witnessed in 2004 with respect to strong growth across sectors and robust FII inflows, we believe that just banking on the latter to take the markets to new highs is fraught with risks. Over the long term, even FIIs will chase fundamentals (read, earnings growth).

Courtesy : Equitymaster Newsletter