Wanted, a strong domestic market

FII flows should be treated as just another barometer of asset values.

"Sell in May and go away" is a common saying amongst those in London's financial centre as they begin to plan their holidays ahead of summer. This year, in particular, many would hope that they followed their own advice! In the last week alone, global markets lost on average 4% of their value, and there still seems to be confusion as to the cause.

The world's stock markets have had a tremendous run but as the balloon kept rising, all it took was the simple change in the perception of risk to pop the bubble.

As markets have risen rapidly beyond their historic levels, institutional investors have been getting more nervous and have been looking for a sell signal to lock in the exceptional profits for the year. Unfortunately, these signals have been vague.

Certainly, the recent announcements by the US Fed on the risk of continuing inflationary concern is one factor, but this alone cannot explain the speed of the markets' correction, particularly when the US inflation figure turned out to be 0.1% higher than forecast! Add to this the weakening dollar and the already high commodity prices, inflationary concerns are on the rise. But these risks have been known for sometime.

The correction has left Indian stock markets down some 20% in two weeks while achieving a record high for volatility. Nonetheless, the Indian stock market is still up 10% on the year and 60% higher over the last twelve months. Compare this to the MSCI index for EMEA (Europe, Middle East and Africa) which collapsed by 19.2% from its peak it hit on May 9 to its worst point on May 22 ; Latin America fell by more than 19.5% while the Asian markets fell by 11% on average.

Fundamentally, very little has changed since last week. The world is still living in an environment of relatively cheap money, but investor sentiment has become more cautious. Some of these investors moved to push the red sell button and caused a rush for the exit. Since May 15, FIIs have sold more than 25-50% of their inflows since January in Korea, Taiwan and Thailand. Given the way the markets staged a recovery, it is clear that not all investors are yet willing to throw in the towel.

The hot money flowing between the stock markets has certainly got spooked. While hot money has flowed out, this has left an opportunity for long-term funds willing to look through the short-term volatility to acquire shares at more reasonable values. Consider markets such as Egypt which after last week's correction, saw stocks trade at an average forecasted PE (price earnings) ratio of 9.4x 2006 and 6.8x 2007 based on estimated earnings growth of 40% per annum for the same period.

Long-term fund managers will also have a particularly strong voice in IPOs where their valuation opinions will be core to underpinning the success of a new float. This has to be good news. The IPOs that get away in these markets are likely to have a much stronger and more supportive investor base for the long term.

The recent volatility has caused developed markets to sneeze and has left emerging markets with a severe cold. Global FIIs are nervous and this means that their commitment to take a long-term investment view on any particular country or even specific stock is under threat.

In the past, this type of correction usually leads to a flight for quality - money is withdrawn from more risky markets to safe heavens in the developed world. However, given the importance of India in any FII portfolio, I would argue that investment funds may change shape but are unlikely to withdraw altogether.

For example, the recent correction saw FIIs sell stock but invest in derivatives to hedge their position. When you net the sells against the buys, the actual outflow of FII funds was reduced to some 15% of the FII inflows since the beginning of the year.

While India's rapid stock market rise may be seen as the best example of the ‘emerging markets bubble,' it seems that investors are less willing to sell up and run just yet. "I ask investors to remain invested," said finance minister P Chidambaram.

Neutralising FIIs' flows is impossible unless you completely close your market to foreign investment which is not recommended. Historically, the FIIs' value in terms of the confidence boost to India's stock market and the growth story has always far exceeded the actual level of investment capital they bring.

Our strong domestic market is rapidly becoming equally important. Regulators and market participants need to focus on creating an investment environment where the FII flows are recognised as another important barometer of asset values rather than the primary one.

The writer is founder of Sphere Partners (www.spherepartners.com) and the president of TiE, UK (www.tie.org)