Just when it appeared as if there was never a better time for Indian equities, markets suddenly crashed. What caused the fall and where do we go from here? By Vivek Sharma

At the beginning of this month, there was hardly an analyst who forecast a deep market correction. The most pessimistic expected mild bouts of profit booking, nothing worse. The majority were confident that good times would continue. Here are a few samples:

• "Very few other markets offer a combination of strong economic growth, stable macro economic environment, good corporate performance, favourable demographics, rising domestic participation and good resilience to US economic slow down in 2008. Concerns over valuations may ease as Indian markets could get re-rated later in 2008" - DSP Merrill Lynch
  
• "We believe markets will be consolidating in FY09. We will be seeing multiple peaks during the year and would likely to trade between 25,500 and 18,000. Our belief is Indian market is largely insulated from the US market" - Religare
  
• "All factors look positive for the market at this point and the market is poised for an upswing" - Angel Broking
  
• "India is no longer a potential market but one that is already living up to its significant potential. Strong third quarter results from Indian companies will further encourage FII buying, especially from those yet to enter India"" - Religare again
  
• "An investment boom, in our opinion, could unlock their full potential. India can soon achieve 10 growth rate" - Lehman Brothers

These statements and analyses reflected the mood that prevailed, when voices to the contrary were being dismissed as being overly pessimistic. To be fair to the institutions quoted above, it was too difficult to take a call against the unprecedented momentum witnessed in the past few months. Fund inflows into the market during the second half of last year were way beyond even the wildest forecasts. Expectations were that fund flows would continue unabated, and could even rise further in 2008 as sovereign funds too joined the quest for profits from the India story.

After all, Indian corporate earnings growth, even if there was a modest decline from last year's levels, was forecast to be substantially better than in other Asian countries. Indian companies were making large investments in capacity addition and expanding overseas through acquisitions. The policy climate remained favourable, with hopes of a modest decline in interest rates. The government was expected to support industrial investments and consumer spending through populist policies, ahead of elections due next year.

Then there was the IPO mania, fuelled by spectacular dreams of future growth potential and nothing concrete on the ground - as in the case of Reliance Power. The extremely aggressive valuation of this IPO led to a dramatic increase in the valuations of other stocks in the sector.

Oil refining stocks tripled and quadrupled in a matter of months on hopes of ever increasing refining margins, even though some of these refineries are yet to go on stream. High product prices drove metal stocks while banking stocks surged on the 'great India opportunity' story and hopes of the sector being opened up for foreign investment by next year. Only technology stocks lagged, as the strong rupee and rising costs ate into margins.

Then there was the great 'decoupling' theory. The proponents of this theory were confident that emerging economies like China and India have cut off their umbilical cords from the global environment and can grow even if the rest of the world sinks into a mess.

They hoped that domestic consumption in these two countries could easily replace any decline in consumer demand in developed economies, and become the new engines of global growth. After all, China and India have built up sufficient momentum and there is nothing to stop them, they believed. No doubt, this theory had many backers and the number of believers only increased with every additional dollar flowing into the emerging markets.

What changed?
Most of the market presumptions, which drove the over 1850-points rally on the Nifty from 4500 have been challenged in recent weeks. The global environment appears to be getting more challenging almost every other day. The credit crisis has not abated and some expect it to get worse before showing any signs of improvement. If not for the readiness of sovereign funds to pump in money, many global financial companies would have struggled to stay afloat.

US housing is yet to bottom out and the weakness has now spread to most markets in Europe, and threatens to drag consumer spending. Inflation risks may prevent substantial interest rate cuts, which the markets expect. To most, a US recession is a certainty. The only question is how long will it last.

The decoupling theory has been thoroughly shaken as the deceleration in exports and higher interest rates seem to have had a claming effect on Chinese growth. Property prices in some of the fastest-growing Chinese cities on the East Coast have declined by close to10 per cent last November. The deceleration in China was expected to happen only after this year's Olympics, if at all it were to happen, but seems to have arrived much earlier. The opening up of Hong Kong stocks to investors from Mainland China, which drove up prices in Hong Kong last year, has not yet happened.

In India too, growth seems to have topped out in the medium term. Last quarter corporate earnings were below expectations - some of the spectacular numbers like those from Reliance Industries and Reliance Energy were on account of one-off gains. 2008 will see significant political uncertainty as we move closer to next year's elections and political realignments kick in.

It is only natural that investors withdraw from equities when the environment becomes uncertain and hence riskier. A substantial part of the money that flowed into emerging markets during the second half of last year was from hedge funds, which shift their market views and positions very frequently. To make it worse, valuations in China and India were highly stretched and did not provide any room for even a modest growth deceleration and for the possibility of a prolonged US recession.
 
Where do we go from here?
It is nobody's case that the entire 'great India growth story' and the investment themes spun around it were all hype and no substance. There is no doubt that the growth outlook for India is better than all other large emerging markets, and maybe more stable than the outlook for China. Our growth is predominantly domestic driven and hence we are relatively better insulated against a global slowdown. Growth opportunities in our infrastructure sector, including power generation, are huge. Indian companies are highly competitive, are better managed and maybe more investor friendly than their emerging market peers.

But, in the spectacular surge during the second half of last year, most of these positives were fully factored into the stock prices. Or, in other words, market valuations were running way ahead of time. At the stretched valuations, there was very little leeway for adjusting to any kind of adverse developments.

A closer analysis of the recent fall makes it clear that those stocks, which had run up furiously were the worst hit. There could be some more froth left in some of these stocks even at current prices. But, the relatively better outlook for India against other emerging markets is likely to prevent a complete retraction to the prices that prevailed when the Nifty was around 4500.

It is also unlikely that markets will try and regain the losses in a hurry. To add to the global uncertainties, the domestic scenario may become more turbulent ahead of the elections. Markets can be very turbulent during and after elections - especially if no political formation has a clear lead. That seems to be the case this time around and markets could see bouts of volatility - like in early 2004 - until a stable alliance takes power.

The next year or so could throw up very interesting opportunities for long-term investors, as there will be better clarity on the progress of many companies with mega plans. When markets remain subdued, these stocks will not fly on every positive development, like they did in recent months, and will provide opportunities to get in at the right price.

This will also be a period to keep a close watch on some of the promising mid-cap and small-cap companies, to measure their evolution and take an investment call. It may also be worthwhile to keep track of the technology stocks, which may see a revival with the next upswing in global technology spending.

A majority of the traders who made huge profits during the last few months would have lost a substantial part of their gains in the meltdown. Those who had leveraged positions would even have lost more than they ever made, as the slide has been totally unexpected and so severe.

This could be a very challenging year for traders, who will find it difficult to make trading calls in a highly uncertain environment when their confidence is badly shaken. They would do well to limit the size of their positions and wait for better days.