FIIs sell $2.7bn since May 12

If foreign institutional investors (FIIs) led the rise in the Indian stock markets, they are perceived to be behind the steep fall as well. FIIs have sold close to $2.7bn (or Rs 11,500 crore) since May 12, almost 50% of their investments during '06. The possible redemption pressure back homecould be forcing the FIIs to book profit in India.

That's in the cash market. But FIIs, who were aggressive buyers in the F&O (futures and options) market till this Monday, have now started selling. The change in their behaviour in the derivatives market signals selling bias in the near term. FIIs' net investment in '06 stands at $2.5bn as of May 31.

To a question whether FIIs are exiting India, a senior analyst with JP Morgan, New York, responded with a yes and a no. "If you analyse the data correctly, FIIs are just booking profits across emerging markets and would definitely invest back at appropriate levels," he said. Other US-based analysts concurred.

But negatives exist too. A Citigroup report states, "While down from its lofty peak, our sentiment indicator remains in the euphoria zone. Most at risk are India and Korea; sentiment is average in Taiwan and Hong Kong."

Citigroup report further states that historically, returns have been negatively correlated to sentiment. When the sentiment indicator has been in euphoric territory, returns have been poor to negative, and when investors are despondent, returns have been positive.

So, are FIIs increasing their cash exposure or are they allocating money into other markets or other asset classes? One factor that seems at play is the redemption pressure, on account of rising interest rates back home, which is prompting investors to move money back into safer asset classes in their home countries.

Said the JP Morgan analyst, "At this point, no re-allocation is happening. Yes, some money is definitely moving out as investors book profits and start investing into less risky assets."

Rising interest rate concerns in the US, weaker rupee and weaker metal prices seem to be the chief worries for FIIs. Easy money was one of the reasons for sustained equity inflows to emerging economies such as India, even when valuations seemed getting out of sync with fundamentals.

"Emerging markets were the biggest gainers with rising liquidity on account of foreign inflows. Now when the liquidity is tightening, emerging markets will tend to suffer," said Brad Durham, managing director, emerging portfolio fund research. The MSCI emerging market equities index has shed nearly 13% in the previous two weeks.

The other conclusion is that a downturn is inevitable after years of a sustained bull run. "Emerging markets are following global cycles, which is largely a four year cycle.

No doubt, India is in a secular upward movement, but we have entered the fourth year of the bull run, and some sell-off is expected. India might see levels of sub-9000 before the secular uptrend starts moving almost unilaterally upwards," said Robin Griffiths, head of asset allocation, Rathbone Investment Management.

The large retail bias and weak domestic institutions are the key to a steep fall in Indian markets said Martin Graham, director of market services, London Stock Exchange.

"Therefore, whenever FIIs sell there seems to be no buying support." The case is similar when FIIs were buying. Domestic institutions did not have the strength to sell at higher levels to keep markets at realistic levels