Indian shares: disappointment may lurk

March 10, 2014

Should Indian shares really be at record highs?

The index is up 3.6 percent this year. Foreign funds have been pouring money into Mumbai shares, betting that the opposition BJP, seen as more reform-friendly than the incumbent Congress, will form the next government. They purchased $420 million worth of Indian stocks last Friday, having bought $1.4 billion over the past 15 trading sessions.

There is also the fact that the rolling crisis in emerging markets, having smacked India during its first round last May, has now moved on and is ravaging places such as Russia and Nigeria instead. The rupee has firmed almost 2 percent this year to the dollar, as last year’s 6.5 percent/GDP current account deficit has contracted to just 0.9 percent of GDP.  Many international funds such as Blackrock and JPMorgan Asset Management have Indian stocks on overweight and Bank of America/Merrill Lynch’s monthly survey showed investors’  underweight on India was one of the smallest for emerging markets.

Indian company earnings may have beaten forecasts by around 5 percent so far in the season. But prospects can hardly be described as attractive. Indian economic growth is running at less than 5 percent. Valuations are in line with historical averages and at a 4 percent premium to global emerging markets on a book-value basis. But John-Paul Smith at Deutsche Bank says it is “the least bad” of the BRICs and is neutral to overweight.

You can see why money is going there, most of GEM looks grim. The question is to what extent a big win for the BJP is factored in. They seem to be moving towards the ability to put together a workable coalition but the outline of their economic policy is not clear. The other story of India is governments can pass laws but implementation is quite different.

Morgan Stanley analysts note that Value-at-risk (VaR), a measure of the level, timing and probability of risk, for the Indian stock market is close to record lows while the recent gains have driven price-earnings ratios to 3 year highs. What this means is India is perceived as “a safe haven in a rocky emerging world”, they write:

The market’s view is that tail risks are not in play. Implied volatility has collapsed, implying that market participants are willing to play a narrow range of outcomes for the near future.

That strategy carries heavy risks, they add. For one, India’s chaotic politics make a BJP government by no means certain; indeed the possibility is high of a coalition comprised of rag-tag regional partie, most of which are broadly opposed to greater foreign involvement in the economy. Morgan Stanley again:

Given the state of valuations combined with the depressed VaR, correlations and implied volatility, it is evident that the market is confident (and/or complacent) about the immediate future of the narrow indices. If a tail event were to arise, the market could fall significantly.

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