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Suresh Krishnamurthy

IN the last decade, the economy has undergone several important structural changes. The stock market faithfully reflected such changes in the prices of stocks. However, an important dynamic change has happened in the last couple of years the stock market does not appear to have considered — the sharp fall in interest rates.

Interest rates and stocks: Ordinarily, the significant fall in interest rates can be expected to reflect in higher stock prices. Long-term interest rates have declined more than 25 per cent in the last year and half. However, a commensurate increase in stock prices has failed to happen. Indeed, index values are virtually at levels seen in June 1999 — since then, long-term interest rates have come down from around 12 per cent to close to 8 per cent now.

A decline in interest rates reduces the rate at which the earnings of the companies are valued. There was also a suggestion that risk premiums for equities would also decline.

The combined effect of both these factors would have theoretically led to an increase in the value of companies and, therefore, led to an all-round improvement in stock prices.

In other words, investors were expected to be satisfied with a lower return from equities. This is, of course, subject to the assumption that other relevant factors, such as earnings potential, have not changed.

However, barring sector-specific rise in stock price increases (rally in PSU, banking and two-wheeler stocks) all-round increase in stock prices has been noticeably absent. In other words, investors still seem to be demanding higher returns from equities.

Will this situation persist? If the decline in interest rates is permanent, it is unlikely that the situation will persist. In this regard, it appears that a significant portion of the decline interest rates is a permanent feature. In that case, there is reason to suspect that stock prices are under valued now, assuming that other relevant factors have not changed significantly.

Liquidity — the culprit: If stock prices are undervalued, why is there not a sharp rally in stock prices? Liquidity may be the main culprit. Strong markets tend to be liquidity-driven. In the Indian market, there seems to be a dearth of long-term investment inflows. FII investments till now have been around Rs 3,000 crore for the year. In contrast, they were around Rs 10,700 crore till the same period last year. Inflows into mutual fund equity schemes have also not been significant.

It is possible that such investor apathy — may be due to justifiable reasons — is the reason for the trend less behaviour of the stock market. It is possible that investors may be waiting for further changes in the economy — such as fiscal consolidation — before giving effect to a lower interest rate scene. Or it may just take a revival in global growth to trigger a rally.

When will things change? That is almost impossible to predict. Perhaps, technical analysts can give us some clue. However, it has been difficult for technical analysts also to predict changes in trends ahead of such changes.

Long-term investing: That leaves the retail investor with no option but to stay invested in the market with a long-term perspective.

The investor should take cue from mutual funds to buy on dips. Mutual funds bought stocks when the Sensex dipped to below 2,600 in September 2001 and profited handsomely. For investors averse to such contrarian strategies, regular investments with a time horizon of more than 10 years in a balanced fund with good record may not be a bad idea at all.

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