REVIVAL IN GLOBAL RISK APPETITE IS KEY TO A SUSTAINABLE EQUITY RALLY AT HOME; RELATIVE INSULATION FROM GLOBAL WOES HAS NOT HELPED AND WILL NOT HELP

I have made the case in the past that Indian equities are cheap by historical norms, but still not at valuation extremes of December 2002. While current pricing is consistent with healthy returns over the medium-term (5-10 years), we are still not in an environment that would be conducive to a sustained revival in equity market fortunes. Indian indexes cannot and will not rally at variance with global risk appetite. Consider the following regressions:

Sensex Total Return (%) = 19% + 0.01 * U.S. HY Excess Returns

Data: 1990 to 2007; Yearly
U.S. High Yield Excess Returns: Return over duration matched treasuries in basis points on the Lehman Brothers U.S. High Yield Index

R-squared = 0.44
t-statistic (beta) = 3.58 (P-value:0.002)

Sensex Total Return (%) = 11% + 0.01 * U.S.$ EM Excess Returns

Data: 1993 to 2007; Yearly
U.S.$ Emerging Market Excess Returns: Return over duration matched treasuries in basis points on the Lehman Brothers U.S.$ EM Index

R-squared = 0.23
t-statistic (beta) = 1.99 (P-value: 0.06)

The key message is a positive relationship between Indian stock market variation and excess returns in U.S. spread sectors. When risk premium demanded by global investors climbs, all asset classes under-perform.

Another way to look at this phenomenon is that the Indian bourses will post significant and sustainable rallies only when foreign portfolio investors return in a big way.

I do not foresee a revival in global risk appetite in the near future. The incessant flow of bad news continues. Trouble in Eastern Europe, never ending issues in the banking system, and massive fiscal deficits; all continue to keep markets on the back foot.

All of the above does not rule out a 20%-30% rally from wherever the market bottoms in the current downdraft, but the sustainability of the upswing will be questionable and I will look to reduce risk as markets move higher.