[ The trouble lies in India's backyard ]

All those who have read Julius Caesar would remember the famous quote attributed to Cassius (the chief protagonist of Caesar) addressing Brutus, (the protege and partner in crime of Cassius), "The Fault, Dear Brutus lies not in Our stars, BUT in Ourselves".

I was reminded of this quote when a friend wrote to me, very tersely, stating that recent land deals in the Bandra-Kurla area of Mumbai have been concluded at upwards of Rs 100,000 per sq feet. Thereby, he intended to challenge my earlier hypothesis that Real Estate an "un-fetterred, unwanted investment " will singly suffice to create "trouble in our backyard".

Ask yourself, a 100 sq feet commercial space in the aforersaid area, would now cost Rs 1 crore. Add to it the normal costs of running a business like staffing, airconditioning, lighting and electricity and we would need to ask, what kind of business would bring in a 20 per cent return on such an investment? More important, would be to ask what business could be run in just 100 sq feet of space...

To be honest, though, Real Estate valuations alone are not the sole areas of concern in the Indian stock markets. The others are the high PE multiples in shallow fields and zero Content segments like Media (Example Sun TV, TV 18, TVToday and NDTV), high price to book multiples for private banks (UTI, HDFC Bank and ICICI Bank), which combined with declining economic growth rate, rising interest rates and a weakening momentum are pointers of doom and not a boom.

Concerns have been exercised about excessive valuations in China, and fingers pointed towards weak data from the US as possible reasons behind the positive and negative gyrations in Asian and other Emerging markets. We could, however, argue that far from a sanguine view, everything fundamental about India seems to have changed.

The Real Economy is now forecast to grow at 7 to 7.5 per cent in FY 2008, a full 1.5 per cent points lower than what has been widely tipped for FY 2007, and even lower than the GOI forecast of 8 per cent growth estimated for FY 2008.

Meanwhile Fixed Asset investment is expected to be scaled up from the levels of $ 30 bn per annum seen over the last 5 years to roughly $ 60 bn and above per annum, over the next 5 years. In a nation where the corporate debt market is under-developed and the GOI is the biggest borrower of funds, it will be the private sector investment which will be at risk of being crowded out, going forth. The resulting competitive pressures would lead to an increase in deposit and lending rates.

Some "A" grade private sector borrowers could take the FCCB route, but with annual cap placed at $ 10 bn there might be borrowing shortfalls and increase in risk premium for Indian borrowers approaching the Euro and Samurai markets.

More forex supply into India, accompanied by rising interest rates will encourage even more hot money flows into Indian banks further forcing the Rupee to appreciate against the Dollar, lowering competitiveness of Exports and the RBI and GOI stepping in to stench domestic industrial and economic growth.

Thus, we would possibly have a spectre of higher inter-bank rates, currency appreciation accompanied by further increase in trade-deficit and inflation. These factors put together, could prove challenging for Equity markets. At the same time, there could be a lot of commentary that will go around, about the elevated levels of asset prices and the need to keep price appreciation in check. So all said, we cannot rule out further falls and more volatility in the market here-on.

If investors are convinced about over-valuation in India, they may find markets where valuations are less stretched like those in Korea and Taiwan. A quite exodus can then begin from Mumbai.

Real Estate: Real Problems

About 25 mn sq feet of developed Real Estate is likely to hit the markets over the next two years, compared to approximately 5 mn sq feet that came up in the last 5 years. Most of this expansion has been built on a 1:7 Commercial-Residential housing-split based upon the logic of derived growth from the IT/ITES segments.

A recent Forbes article spoke about IT related salaries rising by roughly 30 per cent year over year in 2007. This kind of a salary hike will allow the top Technology sector employees to continue coughing up giddying prices for new Real Estate, but it may not be sustainable.

Rising Rupee and Rising Salaries alone will compress operating margins for most of the Technology sector in 2008. The large cap Tech can then become easy ground for shorting by Dalal Street Biggies.

That apart...

At the current economic juncture, the key question to be answered, is whether the market has perceived any weakness in the housing market flowing onto the consumer. So far it hasnt. But it's the next logical step in the cycle. So this is where the investors should focus.

If consumer spending holds up, the investment cycle will too.

In a housing downturn, as I envisage, there are two ways that consumer spending can slow. First, a sharp downturn in residential construction activity causes employment in the sector to weaken, pushing the economy into a downward spiral of slowing employment growth and slowing consumption growth or simply said "the construction sector channel".

The second channel is when house prices stop growing (and instead start falling), the reduced tailwind (headwind) from the wealth effect can slow consumer spending directly, again pushing the economy into a downward spiral of slowing consumption growth and slowing employment growth ("the wealth effect channel").

Where are we now in this process?

It seems we are for now heading into the "the construction channel". A quick visit around the NCR area will show the number of stalled or semi-completed projects standing silently in time.

The "construction" and "wealth" effects take time to manifest themselves. So it is not sound judgement to conclude that "it hasnt happened yet so it wont happen". That said, so far the news flow has been ambivalent.

But chinks in the armour are now visible..

Higher wages, higher demands from Unions for increase in wages for Central and State government employees in PSUs, Banks and Insurance companies. Left led demand for increase in fixed returns on Centrally sponsored Provident Fund schemes, cutting of Oil prices when Crude price is rising, the creation of buffer stock to bail-out the sugarcane industry, twisting the arms of cement producers to lower Cement prices, the complete reversal on land grab issues at Nandigram and Singur, and mum being the right word on SEZs shows the freeze that the Central Government is in, at present.

The RBI whipping out open market operations and year-end bond issues to suck liquidity and for the first time in years, the inter-bank call money rates rising to 12 per cent, a steep increase to the 5 year deposit rate of 9.5 per cent that Banks are now ready to pay.

There is an obvious reversal of conditions in the credit markets, where short term rates now exceed long term deposit rates. A 2500 point fall in the Sensex followed up by a 870 point gain of the Sensex and then another 160 point fall in the Sensex, all in the matter of 5 weeks since late February 2007, suggest volatility will be extreme moving into FY 2008.

When a lot of people have a lot of money to invest, and financial markets are sophisticated a reduction in market volatility is not a surprising outcome. A reversal, signals economic downturns of the magnitude seen in 1990-94, and 2000-2003 when volatility meant just one thing: A fall in the markets.

According to Quants, you should avoid stocks with momentum and hold stocks with good dividend yields.

The problem with the Indian stock markets over the last 4 years was, that it was never a Value proposition but always a Momentum play. Worse, there still are no high dividend yielding stocks on the plate and momentum is dwindling. So where does that leave you? Out of stocks..shall I say? And into Cash.

Source: Internet Groups