Another disastrous week as frontline indices lose 5 per cent each

Rex Mathew
29 October 2005

Most analysts and traders were expecting a short term recovery as the markets appeared oversold during last week. Many of them were expecting a rally as short positions were expected to be covered ahead of the derivatives settlement.

Belying all these expectations and expert calls, the markets continued their downtrend during the week. Continued weakness in global markets and quarterly results which failed to excite, even though they did not disappoint much, exerted more pressure on the indices.

The indices opened the week on an extremely weak note, losing
2 per cent each on Monday. Tuesday was a big day for the markets as the RBI came out with its quarterly review of the credit policy. The policy was in line with expectations and the markets closed higher helped by banking stocks.

After closing marginally lower on Wednesday, the indices saw another sharp decline on Thursday. Contrary to expectations, most traders exited their long positions on the futures segment even though the markets have declined substantially. Thursday afternoon saw a major sell off and both frontline indices lost over 2 per cent each. The markets failed to stage a bounce back on Friday and the indices lost another 1.5 per cent each.

The Sensex lost 383 points or close to 5 per cent during the week and the Nifty shed 128 points or more than 5 per cent over the week.

Mid-caps were relatively better off during the week as the index survived any large sell off during the early part of the week. However, the mid caps which are present on the derivatives segment saw considerable weakness on Thursday and Friday pulling down the indices considerably. Friday was the worst day for the mid-cap index losing close to 2 per cent. The CNX Mid-Cap 100 index lost 130 points or over 3.5 per cent during the week.

Domestic economic and regulatory action

• Wholesale price inflation for the week ended 15 October increased to 4.71 per cent from 4.62 per cent for the previous week. The rise in inflation was attributed to higher prices of minerals, food and manufactured products.

Industry developments

• One of the worst performing sectors during this month's market correction has been the steel sector. Leadings stocks like Tata Steel and SAIL have lost considerable ground and the smaller steel stocks have fared even worse. While Tata Steel has lost 23 per cent from its recent high, SAIL has declined more than 30 per cent. Among the smaller stocks, Ispat Industries has lost 59 per cent while Essar Steel and JSW Steel have declined 36 per cent each.
  
  The quarterly results of most steel companies have been below expectations. The performance of some of the smaller companies has been disastrous with companies like Ispat Industries reporting a loss for the quarter. The performance of global steel companies like Mittal Steel and Arcelor have also been below expectations and their stock prices have also suffered.
  
  This has raised the inevitable question, is the steel cycle turning downwards after years of firm prices? Steel prices have declined considerably from the highs of last year and steel companies have cut prices this year. Even then steel companies remain bullish about the prospects of the sector and maintain that the current decline in prices is temporary.
  
  Various reasons have been given for the soft steel prices. The most repeated one is a slow down in demand from China as Chinese companies have built up capacity and are not as import dependent as before. A more plausible reason is the huge build-up in inventory across the world by steel manufacturers encouraged by record prices. When steel consumers turned reluctant to keep buying steel at higher prices, this inventory got bigger and caused a glut in the market.
  
  Another factor which is changing the dynamics of the steel industry is that prices of inputs like iron ore, scrap and coal have not come down as much as the prices of finished products. Till last year, less integrated players could make considerable profits as the margins were comfortably high.
  
  In the emerging scenario, integrated players who have access to captive ore and coal mines would prosper while the less integrated ones are more likely to flounder. This is clear from the vast difference between the quarterly results of integrated and less-integrated players. While small companies like Ispat Industries slipped into the red, integrated companies like SAIL and Tata Steel came out with creditable performance.
  
  The planned capacity expansions by the industry is huge and unless there is a dramatic increase in global demand, smaller players would find it difficult to compete. The demand from China cannot keep rising forever and other countries like India are not showing anything like the seemingly insatiable Chinese appetite. The entry of large global players like Mittal Steel and Posco with their more efficient processes and scale would alter the domestic scene more in favour of larger players.
  
  
• Another sector which has suffered considerably during the current market downturn is pharmaceuticals. This has been one of the worst phases for some of the frontline pharma stocks like Ranbaxy and Dr Reddy's. The market downturn coincided with a number of negative developments for the large domestic players, making the situation look all the more distraught.
  
  Ranbaxy has lost 36 per cent from its recent peak while Dr Reddy's was relatively less affected, losing 18 per cent. Both these stocks have enjoyed very rich valuations in the past as the expectations were high and margins were robust. Cipla was relatively better off with a 12 per cent decline from its peak.
  
  The worst development as far as Indian drug firms are concerned is the sharp decline in generic prices in developed markets like the US and Europe. Ranbaxy has reported a 25 per cent drop in US generic sales in the latest quarter, mostly because of a decline in prices. Even overseas generic companies like Teva and Mylan have reported a decline in US sales.
  
  When companies like Ranbaxy and Dr Reddy's entered these mature markets in the nineties, there were not many generic companies around and margins were very healthy. Over the last few years, more and more players have entered the market and competition among generic companies has become intense. As a result prices have declined considerably, shrinking the margins.
  
  The big pharma companies have also succeeded in keeping their generic competitors away by extending the patents on many blockbuster drugs. These companies have also been more successful in recent years in their legal battles with the generic players. Hence, new opportunities for generic players have dried up.
  
  Generics have become more like a commodity business with low margins where volumes are of crucial significance. The markets which were valuing these companies as high growth - high margin businesses are suddenly waking up to the fact that they are no better than any other commodity business. Hence the valuations have taken a severe beating. The lacklustre financial performance of these drug companies has not helped matters either.
  
  Larger Indian companies, especially Dr Reddy's, had anticipated this slowdown in the generics business far in advance and had started research efforts in right earnest to develop new drugs. However, hunting for new drug molecules is always an uncertain business and successes are few and far between. After spending considerable money over the last few years, companies like Dr Reddy's is trying to reduce research costs by getting private equity firms to fund such programmes.
  
  There are some who believe that the situation would turn around for Indian companies as many proprietary drugs would go off-patent starting next year. This could open up significant opportunities for Indian companies who have already initiated efforts through increased drug filings in the US and Europe. The fact that generic drugs could account for almost half of the overall US drug market in another two years augurs well for these companies. Even the governments in these companies have started favouring generic products to lower the healthcare bill.
  
  The commoditisation of the generics business could possibly lead to consolidation in the near future. Large global players like Teva of Israel have already completed some buyouts. Among the Indian companies, Ranbaxy is on the lookout for a large overseas buy. Dr Reddy's is also eyeing a large acquisition in Europe. Acquisitions would help in achieving the required size though integration of operations may prove dicey. However, Indian companies have been fairly successful in overseas acquisitions though the size of the deals has been small.

US markets, global economy and oil

• US markets closed with weekly gains for the first week in October as strong GDP growth for the third quarter ended September and robust corporate numbers led to a massive rally on Friday. All three frontline indices gained substantially on the last day of the week after witnessing a mixed trend earlier in the week. The markets had opened with strong gains on Monday after the US government announced its nomination for the chairman of the US Fed. The gains were given up later in the week.
  
  For the week, the Dow added close to 2 per cent while S&P 500 gained over one-and-a-half per cent. NASDAQ, which had closed with marginal gains during the previous week when other indices were weak, added less than half-a per cent.
  
  
• US economy expanded at a higher than expected 3.8 per cent for the third quarter ended September. GDP growth was higher than the expectations of most economists who had forecast a growth of 3.5 per cent. Higher oil prices and Hurricane Katrina were expected to have impacted growth during the quarter. The US economy had expanded 3.3 per cent during the second quarter.
  
  The reconstruction efforts after the recent hurricane damages are expected to push up US economic growth further in the fourth quarter. The US federal government and local governments have launched a massive rebuilding programme. The businesses which were shut down during the natural calamities and the jobs which went away with them would come back in the last quarter, adding to the economic momentum. Lower oil prices are also expected to help.
  
  However, growth in consumer spending during the third quarter was lower at 1.3 per cent as compared to 1.7 per cent during the second quarter. The consumer confidence index has also slipped during October indicating some possible impact on spending during the holiday season. Some analysts believe that the fall in consumer spending is entirely because of higher fuel costs and would recover if oil prices decline further.
  
  
• The US Fed is expected to raise short term interest rates by another 25 basis points next week. If announced, it would be the 12th consecutive increase over the last two years. The same policy stance of measures rate hikes is expected to continue as US economic growth remains robust despite higher oil prices and natural disasters. Inflation outlook among consumers have also jumped to their highest levels in recent years making a reversal of the policy less likely.
  
  
• The Chinese economy expanded 9.4 per cent during the first nine months of the current year, almost at the same rate as last year. The Chinese GDP for the first nine months is at $1.3 trillion as per preliminary estimates released by the government. Consumer price inflation is at 2 per cent, considerably lower than last year.
  
  China continues to do perform exceedingly well in the external sector. Exports during the first nine months rose more than 31 per cent to $546 billion. Imports during the same period were at $478 billion, a growth of 16 per cent. Trade surplus is still considerably high at $68 billion.
  
  The contrast with India is a real eye opener. India is hoping to achieve exports of $100 billion for the full year and we have already run up a trade deficit of $20 billion during the period April-September. We gloat about forex reserves of $140 billion while Chinese reserves are at $769 billion. These figures alone are enough to suggest that we have a long way to go before coining words like Chindia and imagining that we have arrived on the global centre-stage.
  
  
• Crude prices were more or less flat during the week as a brief rally earlier in the week could not sustain itself. Crude futures for December delivery opened on a flat note on Monday before gaining ground on reports of an early winter in the US which could lead to higher demand for heating oil. The decline in crude stocks as per the US weekly data held oil prices firm during the middle of the weak. The last two days saw a decline and the commodity closed at $61.22, a per cent higher than last week's closing levels.

*Disclaimer: The author may have positions in the stocks mentioned above at the time of writing this article. This analysis/report is only for the purpose of information and is not an investment advice. Readers are advised to consult a certified financial advisor before taking any investment decisions. While efforts have been made to ensure the accuracy of the information provided in the content the author or publisher shall not be held responsible for any loss caused to any person whatsoever.