The country is riding a `quality' wave, yet caution should be the watchword for investors.

The Sensex crossing the magic figure of 13,000 in Monday's trading, bouncing back double quick from the lows of May/June, exemplifies the India growth story. Corporate fundamentals continue to be robust, a fact borne out by the second quarter numbers. Lending a positive thrust to market sentiment is the growing global ambition of Indian companies. Also, more and more multinationals are buying into the India story, the overriding themes being business opportunities in outsourcing and a boom in domestic consumption.

Foreign institutional investment flows that sputtered in mid-May are up smartly and the froth in the market that had built up from the leveraged positions in the futures and options segment in early May is not evident now. As one of the strongest Asian performers since April, this rise supports the overall thesis that the country is riding a `quality' wave. Yet, despite all the positive news flowing into the market, caution should be the watchword for investors. From a valuation perspective, the price earnings multiple of the Sensex stocks, at 22, is stiff with the market returns also being subject to a higher degree of volatility. The elements of concern are: One, the bounce back has largely been powered by a narrow set of index heavyweights, while the bulk of the mid- and small-cap stocks continue to languish. This is understandable because in a market recovering from the meltdown in May, investors tend to flock to quality large-cap stocks thereby pushing up their prices well above what their fundamentals would justify. Two, the transient nature of support, rally having come on the back of weakening crude oil prices, the stable global interest regime over the past quarter, and a sharp run-up in the global indices, both in the developed and developing markets. If the international investor perception were to alter on any of these counts, there may be a sharp correction.

There is every likelihood of that happening. The market remains vulnerable to external shocks on the interest rate front with the Bank of Japan and the European Central Bank remaining hawkish. Fears of a US slowdown have re-emerged, if the latest GDP numbers are anything to go by, and crude oil prices that have softened sharply can turn out to be a wild card. Corporate India will have a tough task of meeting market expectations over the next few quarters as the current valuation warrants a sustained increase in profitability.

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(This article was published in the Business Line print edition dated October 31, 2006)
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