Key risk for stockmarkets?

There are two developments that have been time and again making to the headlines of Indian business newspapers since the last few months. These are 'New highs for Indian stockmarkets' and 'Record FII inflows'. Well, actually, the above should be in the interchanged order as the consistently robust FII inflows have been pushing the Indian stockmarkets to higher territories. However, with every rise, there is a heightened risk for investors, as markets cannot move in a single direction for 'eternity'. Considering this, one financial company has conducted a poll on their website wherein they asked the viewers, "At the current juncture, what is a key risk for the stockmarkets?"
The results of the above poll did not come as a surprise, which shows that investors believe 'FII outflows' to be a biggest risk for Indian stockmarkets at the present. 51% of the votes were garnered by this option. This was followed by 37% votes to 'high expectations' and the balance 12% to 'politics'. Throwing some light on each of the above in brief.

FII outflows: The concern with respect to 'possible' FII outflows stems from the fact that FIIs have pumped in huge amounts of money into Indian equities since 2003. After the record-breaking inflows of US$ 6.5 bn (2003) and US$ 8.5 bn (2004), these have been much stronger in the current year to date at US$ 3.3 bn already. As mentioned, one key factor that has been attracting foreign money into the country is the strengthening Indian currency against the US dollar. Or, to put it better, the weakening dollar against the Indian rupee.

For FIIs, investing in US currency denominated assets is not a relatively lucrative option considering the widening US trade deficit gap, low interest rates and a jobless US economic recovery, which could further put downward pressure on the US currency. On the other hand, their investments would not only reap the benefits of strengthening Indian currency but they would also gain from the strong prospects of Indian equities, which is improving on the back of better cost efficiencies, higher productivity and strong consumption led domestic growth.

So, where is the risk here for Indian equities? The risk arises from the fact that US interest rates are on the rise. After having risen from 1% to 2.25% in 2004, these are expected to rise to about 3.5%-4% as has been indicated by the US Fed authorities. In such an event, investment in US bonds and government securities would become relatively attractive (and safer) for FIIs compared to the prevailing scenario. Then, there would not be a strong case to maintain high investments in developing countries like India. However, while many do not foresee a reversal of FII inflows in the near to medium-term, a considerable slowdown of the same cannot be written off. It must be noted that domestic equity investments are in no way sufficient to meet the shortfall.

High expectations:This is the characteristic of any bull market. Investors start to believe that the strong performance of equities would continue for years to come (not that they cannot) and the stock prices would continue to give mind-boggling returns! However, what investors need to be cautious about here is from investment advise/calls in those sectors/stocks where only the assigned valuations have been increased without a corresponding increase in earnings. This is because valuations of a sector/stock do not change, or rather should not change, with market sentiment.

Valuations warrant an upgrade or a downgrade only if there is a fundamental change in the core business of the company. Investors need to understand that in the long term, fundamentals and not expectations guide stock prices. This fact has been proved time and again. Though there may be short-term volatility, as traders get in and out of stocks, hold on to fundamentally sound companies. They are surely to realise their worth sooner or later.

Politics: While considering the top-down approach of investment, politics is rated next only to economy, which is at the top of the ladder. In fact, the importance of politics (read good government) can be gauged from the fact that government policies have a very strong impact on the performance of all the three constituents of a country's output - agriculture, industries and services - which is consequently reflected in the stock price. Policies affect investment decisions - both by international and domestic investor community - as they would be wary of losing their investment (or not making sufficient returns) in the event of economically unfavourable policies.

Thus, after having gone through each of the options in a little detail above, many believe that at the current juncture, FII behaviour remains one of the key concerns. Considering that a large chunk of the FII monies coming into Indian equities is part of hedge funds, it makes us want to be more cautious. After all, hedge funds are known for their 'fair weather friendship'. However, apart from keeping a close watch on the movement of US interest rates, investors would also need to tone down their expectations from equities from hereon. As far as politics is concerned, while the current government has been accepted well by investors, a close eye needs to be kept on the ruling governments allies also. However, to conclude, in order to hedge the impact of the above risks to some extent, there is a need to invest in only fundamental sound companies.

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Very good and informative writeup. Long term only fundamentals count-I agree. Actually in my view technicals are better used to time entry and exits for investments. Today, some technical analysists have been royally rubbihsed in some of the yahoo forums. A CNBC speaker also said that nobody can really predict the markets and that is something of a media compulsion.

In trading, there is this assumption that 2 or 3 out of the 10 trades would do well and cover up for the rest. That too cannot happen all the time if the mkt reverses suddenly. Maybe the 2-3 trades are of low value or relatively low volatility- it is still a high risk propostition. I have read in books that many people earn more through newsletters/softwares then out of trading in the markets. In any case if Technicals were really good, why should there be so many fancy hedging strategies.

If you ask me the very basic premise of technicals that market behavior repeats itself is highly fallacious. If it did, markets would be predictable but you will not hear a single analyst say that. If only there were some independent credit rating agency like CRISIL monitoring their recommendations and rating them. Most would end up like penny stocks.
Excellent Posts with good insights. Just wanted to add a few from my side.
1) Though there is this strong belief and understanding that FII's inflow has kept the market upbeat, i have always gone against that theory. Yes, i agree that there is some truth to it and that FII investments have really flare up the market, but it is not the only reason for the market reaching new highs. I believe it was time that market truly broke out of it's trading range and the 6000 mark. Which is what it did. Supported by the new government. I believe one of the strong factors had been the new government. Which has 3 very strong financial brains of the country who have served as finance ministers earlier on.
2) As with anything, valuations are too stretched out at this point. To the extent that many stocks trading at a p/e of over 100. This really is a point of concern. Agree that fundamentally nothing has changed, but project earnings growth and other factors do come into the picture.
3) Technical analyses does really work if used appropriately. Agree that success ration may be less. But i would say it would be at least 50-70% range rather than the 20-30% posted by Sh50. While i respect everone's thoughts, this is just mine. I have been doing Technical analyses for quite a while and i would say this is the range i look for. Highly recommend doing your Research Online at, all for FREE.
4) As for the upgrades/downgrades. Everybody knows what analysts are after when they issue an upgrade/downgrade. :).

Excellent posts again.

The stock market decline in the second half of March.

As for stocks, the big run-up of the past year is tapering off alarmingly. A bit of selling by foreign institutions last week and warnings by certain corporates regarding the adverse impact of VAT on sales sent jitters down the market's spine. Stocks fell sharply mid-week before recovering in the last two sessions.

The obvious question is: if we are headed for a bearish or jittery market, how can stock investors safeguard their investments?

"One way to do so is to shift focus to defensive stocks."

Another good way would be to always be prepared for a bear market. Learn to short as boldly as u go long. Trust me u will make more money :D
Though the indices gained quite nicely yesterday, they are really at the same levels from where they set off at the start of the week. In effect, the markets are moving in a narrow range, gaining in one session and losing in the other. While this may be frustrating for investors who had gotten used to seeing their portfolio gain, week after week, it may be a sign of investor sentiment slowly maturing.

It can be seen that a correction is healthy for the investor from two perspectives. One, it acts as a reality check, avoiding a heady bull phase (like in 1992 and 2000) and the pain post that. It is a healthy sign, as it is foolish to assume that indices will keep going up and only up. Secondly, a correction helps investors re-assess their risk-return matrix and allows new investors, who had missed the bus earlier, to try and make an entry, thus adding to the depth.

FIIs continue to be the key drivers of the Indian or rather the emerging stock markets. And that trend is likely to continue in the foreseeable future, despite the thrust on retail participation. But with equities enjoying 3 way tax benefits (tax free dividend, longer term capital gains is zero, as well as freedom to choose a tax saving mutual fund - ELSS, within the Rs 1 lakh ambit), it has become really a very attractive and viable investment instrument. In effect, the movement has been forward looking, aiming to build an equity culture in the country.

If we look around, we increasingly see a lot of new entrants, both local as well as foreign, offering new ideas, services and products to the Indian consumer. It underlines the potential they see in the Indian economy.

In this light, the Indian indices are likely to see newer highs. Sticking with ones investment for a longer horizon will only help, if one continually enter and exit (it only fattens broker's purse and give ones tax worries).

"Stay invested in quality stocks for long time."

Dear Nkpanjijiyar,sh50 and all others,
How come I have skipped such an interesting poting before I never no .But better let than never!! Its highly informative really very interesting.I think this topic needs to be carried over every day,in a proper analytical way,as of today,and the days before.
Thanks again for all the good work---joy_mitali
The trend of dropping earnings multiples over the past decade suggests it is better to be conservative and assume that the market will continue to be undervalued in terms of forward growth multiples.

To play teenpatti (three-card poker) or five-card western poker well, a gambler needs numerical skills, nerves and an understanding of psychology. All these attributes are also useful for investors.

Different groups of teenpatti players have different styles. Some games are very aggressive, with players 'blind' and bluffing. Other games are conservative - everyone 'sees' early and packs without good cards.

An aggressive player in a conservative game gets killed because he insists on bluffing when his opponents have good cards.

A conservative in an aggressive game makes less money than he should because the others know he plays only with good cards. Successful teenpatti players adapt to blend in and thus maximise returns.


A stock market investor requires similar skills to maximise returns. An optimistic investor gets killed in a conservative market because he buys high. A conservative investor underperforms in an optimistic market because he sells early.

Using theoretical valuations without reference to the characteristics of a specific market also leads to underperformance.

"Be careful while playing in the Stock Market"

In the current times, when the markets are quite volatile, risk can well be associated with paying a higher price for a stock that does not justify value of the holding or that already factors in the growth for the next few years. And in these times, it is an imperative for stockbuyers to give heed to one of the breakthrough concepts of investing given by the 'father of intelligent investing,' Benjamin Graham.

Known as the 'Margin of Safety', this concept has been (and is) very essential while investing in stock markets. This concept, generally, applies for other investment avenues like bonds. For instance, a company must earn a pre-tax profit of more than five times the total interest cost for its bonds to qualify as investment-grade issues. In simpler words, if a company 'X' has interest charges of Rs 10 per annum, it should make Rs 50 as profit before tax for its bonds to qualify as investment grade instruments. The excess of profit after paying interest provides a sense of comfort for investors. And this is called the 'margin of safety,' which acts as a protection to investors against any loss in the event of some future decline in net profits.

Now, can this concept of 'margin of safety' be applied to common stocks (or stocks)? Graham says yes, but with some modifications. For ordinary stocks, the margin of safety lies in an expected 'earning power' considerably above the interest rates on debt instruments. Simply calculated, earning power is equal to the reciprocal of P/E ratio, i.e., E/P. For example, a stock with a P/E ratio of 8 has an earning power of 1/8, or around 12%. In common parlance, this is often known as the 'earnings yield.'

Considering the above example, assuming that the stock has an earning power of 12% and that interest rates on a 10-year bond is 5%, then the stockbuyer earns an excess of 7% over bond, which is a margin in his favour. While such bargains are hard to find in these times, the level of margin a stockbuyer considers safe is dependent on his ability to take risks.

However, having a stock with a high margin of safety is no guarantee that the stockbuyer would not face losses in the future. Businesses are subject to various internal and external risks, which may affect the earnings growth prospects of a company over the long-term. But if you have a portfolio of stocks selected with adequate margins of safety, you minimise your chances of losses over the long term. In this context, stock selection is of great importance. Now, while losing some money is an inevitable part of investing, to be an 'intelligent investor,' you must take responsibility for ensuring that you never lose most of all of your money.



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