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This article will help readers understand the reasons for the current market turmoil and how they can benefit from stocks in this hard time of very high market volatility.

1. What has happened to the Indian Equity Markets?

2. What is the best way forward for investors?

The BSE Sensex rose from a low of 2594 in 2001 had touched a high of 21200 in Jan 2008. It has risen 700% in absolute terms in a span of just 8 years. This rise in the Index has current economic growth factored in, but what made it dangerous is the stretch in valuations was increasing at a much faster rate than the earnings themselves.

A lot has happened in the global and the Indian equity markets in the last six – seven months. As of the weekend, the Sensex is trading at 12600 - a fall of 40%. The market cap has reduced from Rs 72 lacs crores in Jan 2008 to Rs 42 lacs in mid of July 2008. This erases all gains made in the stock markets for a period of almost 15 months, in the year to date.

The Foreign Institutional Investors or FIIs have invested over 150 billion US dollars in the Indian Equity Market in the last decade, of which they redeemed only 7 billion US dollars in the last 6 months. This is 4.6% of the total dollar amount still invested in the Indian Stocks. If they were so negative about the Indian Economy and its growth, they would have removed 95% or all of their money in this country.

Think! Just to give you an idea FII invested over 17 billion US dollars in just 2007 in India. They sold only 7 billion US dollars worth of Indian stocks. It is less than 5% of their holdings. Indian Financial Institutions, Mutual Funds and Insurance Companies have invested an amount in excess of 7 billion US dollars in the Indian Equity markets. Unlike in the past, when there were scams in the market by Harshad Mehta and Ketan Parekh, in the years 1992 to 1994, there is no Scam in the market today. The economy is growing in the area of 7% plus and with average inflation of 8%. In the coming years one can expect a 15% return from the equity markets.

If so, then why are the markets down??? Let us go back about a year to June 2007, when the first news of the global credit crisis came up. Total losses and write-downs from this crisis are expected to reach 1.5 trillion US dollars, of which about 1 trillion US dollars worth of credit losses are already reported and about 400 million US dollars worth of capital has been raised so far.

Things are also getting worse as the fall of the housing market in the US depresses financial institutions further. US Banks and investment houses are losing money and are redeeming their investments from almost all capital markets globally. Most of the FII which registered and invested in India in the last year were momentum investors. Thus the money they bought in the stock markets was looking for quick gains. You saw the corresponding increase in Sensex at 15500 in July 2007 to 21200 in Jan 2008, raising the Index almost 36% in a span of only 6 months and stretching the valuations a bit too far.

This phenomenon has been seen with most emerging economies in Asia as China’s stocks valuation were also stretched to very high levels. Thus extremely high valuations in India and China, a credit crisis back in the US and some of the FIIs started booking profits and sending money back to the home country. And this happened in a bit of a hurry leading to panic and finally a market crash.

To add to the pain, some of the Indian promoters, financial institutions and corporations also took advantage of the very high valuations and unloaded their holdings to the Indian public at large. There were very few buyers in the market and the fall continued.

During the last 6 months a part of the FII money was now being invested in countries with a high concentration in commodities such as oil, metals, and food. Both Brazil and Russia were trading at low valuations. Stock markets in Brazil and Russia were the beneficiaries of this move and we have seen these two countries' stock markets give positive returns this year.

As a result, commodities started becoming expensive and crude oil rose from a steady 80 US dollar a barrel in Jan 2008 to 148 US dollar to a barrel in mid-July 2008. The rise in these commodities, especially oil, is attributed somewhat to reasons of supply and demand, due to global concerns of war and conflict and rising consumption by India and China, as well as some pure speculation.

But the fact is India’s demand for global crude oil has increased only 1.5% where as the US has seen a fall in demand to the tune of 25%. Europe has not seen any rise in crude oil demand. China is moderately reducing its crude imports. And there is an excess production with respect to this demand. Therefor all these factors should lead to a fall in crude prices in the near term.

Going back to the US, which is also the world's largest consumer, as its economy is shrinking and shows all signs of recession, the rise in fuel prices, metals prices and food prices is leading to high inflation, or 'stagflation'. It is a difficult scenario as the federal bank and the US government are struggling to figure out what should be taken care of first - recession or inflation.

Back in India the rise in the prices of crude oil has impacted foreign exchange reserves because of the increased burden of payment of dollars to oil producing nations. As of today the cost of oil imports is about 40% of the country's total exports. India imports 1.1 billion of oil annually with the current cost of crude for India approximately 120 USD a barrel.

The FIIs are going for short trades in the equity market on every piece of bad news and making profits by selling high and buying low in the market, leading Indian investors to lose money and faith. As the government is not passing the entire price increase off to consumers and giving price subsidies to them instead, there is no incentive for the Indian public to consume less or change their consumption habits and help in conservation of petroleum products. Subsidies and oil bonds issued by the government increase the fiscal deficit. It has already increased from 2.5% a year ago to 4.5% today. Add to this current inflation imported to India because of oil and metals, and you have higher interest rates, across the board.

The government, in a bid to control inflation, has increased its various interest rates and some more interest rate hikes are expected in the next 12 months as inflation is not seen reversing soon from its current levels of 11.86% WPI. Thus the 10-year government bond is trading at a yield to maturity of almost 10%.

All the above factors could lead to a slowdown in capital expenditures as well as spending by the consumer as they may postpone their decision to take a home loan, or buy an automobile, with interest rates very high. The GDP growth estimate by the central bank has now been revised to 7.5% vs. an assumption of 8.5%.

It is very attractive if you compare the following growth forecasts: US: 1.3%, Europe: 1.5%, Japan: 0.7%, China: 9.8 %. It is expected that the high rupee-dollar exchange rate will help exports growth. Textiles are the largest export item from India. The Chinese Yuan has appreciated against the dollar in the last six months. And it is expected to appreciate further. This can help Indian exporters become very price competitive against Chinese manufacturers.

Hopefully the government will sign onto the nuclear deal soon. Hopefully India will have a government with a full majority after the elections so that reforms take place. Hopefully some more oil fields and reserves will be found like those in Rajasthan. Government spending on infrastructure will continue to be a catalyst in the long term growth of our economy.

The companies which can pass on the increase in the input cost to the consumers without much of a problem will continue to be profitable. There may be some more bad news still to come but Indian stocks are looking cheep and at very attractive valuations in many sectors. High inflation is a temporary phenomenon, and will subside with time. I do not believe our GDP growth rate will fall to 4% from the current growth rates because of inflation. The recovery will not be fast, however this crash has given investors an opportunity to invest at lower valuations and to create a strong growth portfolio.

Remember the investment returns in 2002 when the market was at the 2800 level, annualized out to 40% a year over the following 5 years. India's economy remains strong, the FIIs are not going anywhere and so it is sad Indian investors themselves have no faith in their own economy.

I am not saying you will get 40% for sure but definitely there is some serious money to be made. With the economy growing in the area of 7% plus in the coming years and with average inflation of 8%, one can reasonably expect a 15% return from the equity markets on a long term investment. Don’t look to time the market, instead try to increase the equity exposure of your portfolio and you're likely to realize some very good returns in the years to come.

Disclosure: None

Source: India's Strong Growth Should Continue