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Mumbai was one of last year’s high flyers, but now that the Bombay Stock Exchange (BSE) is down 6.4% year to date, we've spent this week figuring out what happened.

Two things immediately come to mind:

  1. Mumbai was looking overvalued, and still does. The BSE ran up 20% last year between January and its 21,000-point peak in November. Now it is down 8% from its high, but there is still room for these stocks to correct before new money can find a decent entry point.
  2. Inflation. Food prices have soared 18% in India and have led to outright riots in other parts of the world. This is a political hot button that may drive Delhi to adopt non-market-friendly policies as it tries to fight the trend.

Remember, this is a country where onion prices helped push out a state government in 1980. Food is not just a huge component in overall wholesale inflation of 8.4% — which would ordinarily be alarming in itself — but the key to the entire political set-up.

Throw in rising oil prices, and Delhi will almost certainly raise interest rates fairly aggressively -- which will in turn put a wet blanket on corporate earnings and depress forward valuations.

When playing this market, you have got to be selective. Right now, we are bearish on Infosys Technologies (NYSE:INFY), Sterlite Industries India Ltd. (SLT) and Dr. Reddy's Laboratories Ltd. (NYSE:RDY); more losses are in store for these companies, which are still fairly richly valued.

On the up side, we are bullish on Tata Motors (NYSE:TTM) and Wipro (NYSE:WIT). Going against the herd, we also like HDFC Bank (NYSE:HDB) and ICICI Bank (NYSE:IBN), as we think the interest rate hike will help the banks.

Source: How to Play the Indian Pullback