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Indian SENSEX lost over 12% last month. The primary reasons for the sudden drop were high inflation, fear over interest rates, increasing commodity prices and higher fiscal deficit. The fear of market was warranted not only in terms of concern over inflation and key economic parameters but also in terms of market valuations. In that time, the overall market appeared overvalued and over bought. Market reacted sharply and that led to the massive sell off, resulting in a more than 10% decline in just one month.

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Source: BSE Sensex(Historical Daily Data)

First, The FII acted quickly and moved away funds to other attractive assets, resulting in a steeper decline for the Sensex. Over the last month, FII withdrew over $1B of funds from the Indian equity market.

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Source: SEBI ( FII Statistics)

Let’s look at the Sensex valuation. The average PE of Sensex for the last thee years stands at 19.3 and median at 20.57.The current PE at the 18395 level stands at 20.64 which is higher than the long term average.

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Some of the key risks for the Indian market are:

1. Inflation: For the week ending January 22 WPI climbed to 17.05% (Earlier, it was 15.57%).

2. Higher Fiscal Deficit: For April - Dec period total fiscal deficit stands at 83.03B, over 5% of Indian GDP. Government received INR3.91T as tax receipts and expenditures were INR7.87T. It certainly needs some remedial action like a tax rate hike but again it would be tough to implement in the current environment.

3. Higher commodity Prices: India imports two-third of its crude oil and political tension in Egypt is not helping.

4. Government indecisiveness to tackle political and strategic issues: In recent months there were so many instances where government has either delayed or did not show strong will to solve corruption related issues.

To tackle inflation, the RBI has increased the lending and borrowing rate by 25BPP, it was the seventh increase in the last year. Overall there is no concern about GDP growth, India should be able to achieve 8.5% growth in FY 11 but the overall investment environment would be favorable only if it is combined with low inflation and a low interest rate environment and that will take some time before it happens.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Source: What Are the Risks for the Indian Equity Market in 2011?