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S. Vaidya Nathan

COMING off a year when the broad markets have turned in returns of about 100 per cent (S&P CNX 500), it may be better to view the outlook for stocks in 2004 with circumspection.

It is unlikely that 2004 will hold a positive surprise of the 2003 kind. Equities as a class may end the year with returns that are modest — about 10-15 per cent.

Strong FII flows and signs of economic growth in the vicinity of 6 per cent could take stock prices to substantially higher levels. But that would take them way out of alignment with fundamentals. As an investor, approach 2004 with modest expectations regarding returns and anything beyond that would be a bonus.

It is quite likely that stock prices would seek higher levels before profit-booking takes some steam out of the bull market. Stock-specific stories may hold room for larger-sized returns.

Next year, stock selection would prove critical, unlike in 2003 when one could have walked away with fancy returns in eight out of ten stocks of companies with a credible business story and in almost every stock of non-descript companies.

Corrective phase beckons: The valuation levels in terms of price-earnings multiples (PEMs) have increased sharply through the year. In large-cap stocks, there may be limited room for a sharp expansion in PEM levels. The potential would be greater in select mid-cap stocks and a small number of small-cap stocks of companies with a credible business model.

A corrective phase for the relentless uptrend is also inevitable; the longer the rally lasts, the greater would be the time-span over which such a corrective phase will pan out. It is, however, unlikely that such a phase would wipe out the gains of 2003. Unlike in the bull markets of 1992, 1994 and 2000, prices are unlikely to retrace to levels close to or lower than from where the uptrend started this year.

FII interest: Much of what may be in store will hinge on the direction, degree and magnitude of foreign institutional investors (FII) interest. Having poured in approximately $7.3 billion, they are unlikely to indulge in large-scale selling even if they churn their portfolio and book profits. That protects the market to an extent on the downside.

If the fascination with the India theme continues, there may be more sizeable flows in the offing. Valuation levels may not be a deterrent as FIIs have been comfortable in markets such as Taiwan, Thailand and Korea where PEMs are at substantially higher levels. If they feel confident that they can walk away with even a 15-20 per cent incremental return over the gains of 2003, one can expect sizeable interest.

Even if FII flows in 2004 revert to the levels of about $1-2 billion that has been the range over the past decade, it may prove a strong underpinning to equities. The effect of such inflows, especially if they come through in the initial months of 2004, may get magnified by domestic investor interest. Front-running by big-ticket market players may happen in anticipation of higher quantum of inflows from FIIs, as was the case in 2003. This may also provide impetus to equity prices.

Domestic factors: Even as these factors may provide momentum to the ongoing rally going over the next few months, the focus will also shift to issues of growth. The good monsoon of 2003 may drive industrial growth over the next six months. If the next monsoon is close to normal and spatially well distributed, the industrial and services economy may witness respectable growth rates, even on the higher base of FY 2004.

Even if the economic growth rate slips a couple of percentage points, the story may not get too negative for equities for, at least, a year. The focus on cost-control has provided Corporate India with a few percentage points of higher profitability that is unlinked to the economy. Lower interests costs would continue to add sheen.

Key tracking points: The sectors that would be vital in sustaining growth rates would be auto and housing. The kind of growth rate posted in the passenger cars and commercial vehicles segment in 2003 may not continue. But a repeat of the high rates of 2003 kind is not priced now. Unless the auto numbers trip badly and slide to lower single digit levels, there may be room to sustain valuation levels in auto stocks.

Commodity prices will continue to be driven by the Chinese factor. If and when this plug is pulled, the downside risk can be significant and swift. But with the 2008 Olympics just a few years away, strong infrastructure spending there may ensure a firm undertone in demand for key commodities.

On the domestic front, expect the Government, in an election year, to do its best to keep the momentum going with higher infrastructure spend, which would augur well for steel and cement.

Steel for risk: The big risk that looms large is the prospect of rising steel prices casting a shadow on the profitability of user industries. Automobile companies have announced modest price increases, which will require them to absorb a part of the hike in input costs and hope to drive growth through volumes.

Cement prices may settle at higher levels with the demand-supply balance improving, especially in the northern and eastern markets.

Higher steel and cement prices may not spike the housing sector boom as low interest rates and tax incentives constitute a potent combination that may deter postponement of construction activity. Spending on the road projects may also provide support.

What lies ahead: If economic growth stays at 2003 levels, the downside risk may be modest. Equities could recover a part of the ground that may be lost in a corrective phase.

Investors should, however, gradually take profits on a part of their portfolio. But such an exercise can be placed on hold for at least a couple of months as the bullish sentiment is likely to extend itself. If you are investing fort the long term, use systematic investment plans of select mutual funds to channel your investments into equities in a phased manner.

Action points in 2004

Sectors to watch: Auto, cement, paper, steel and banks.

Stocks to watch: Track the following closely as they may be some stock-specific stories with prospects for delivering returns from the present levels.

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