Will the market rally be sustained?

add_main_imageFor most of 2012, the markets and the economy have been divorced. That story continued on Thursday when the local stocks rose to a 19-month high even as some pundits made dire predictions about national income figures that will be released on Friday.

In this instance, it seems investors may have been cheered by positive news, such as the government agreeing to a vote on foreign direct investment (FDI) in retail in Parliament and the recent reports from rating agency Moody’s Investors Service and brokerage Goldman Sachs suggesting that the worst is over for the economy.NextMAds

The question that now remains is whether the local equities rally will be sustained. In terms of valuation, the Sensex is trading at 15.6 times one-year forward earnings, pretty much near its long-term average, suggesting that the markets may not have galloped all that far ahead of the economy.

But the answer to the question is more a function of whether concrete steps are being taken by the government in living up to some of its promises. For example, whether the vote on FDI will be followed up by the passing of key Bills in this winter session.

In any case, reforms such as FDI are good for the economy in the longer term. In the short run, the challenges lie elsewhere and boils down to execution. One, how the government can kick-start the investment cycle, and second, how it can bring the fiscal deficit under control.

There has been much talk about this—measures such as setting up of a national investment board and the finance minister asking public sector units to “use it or lose it”—referring to their cash piles.

The cash transfer scheme, at least in theory, should take away some pressure off the fiscal deficit.

However, there is no sign that the corporate earnings will dramatically improve. Price-earnings multiples can rise only when the markets believe that earnings will go up sharply. Whatever muted expectations from there have been factored in for sure, but to see significant growth in revenue, one needs to see momentum in economic growth.sixthMAds

But signs of improvement are iffy. Even the external environment is a drag given that export growth is slipping. Conditions in Europe remain delicate and there is no clear sign whether China will turn around.

Therefore, while hopes of positive news flows may lead to a spurt in the near term, markets are unlikely to move linearly. If the government’s reform promises are not executed or say, the central bank doesn’t cut rates in the fourth quarter, this rally will be short-lived.