For instance, according to the earnings review by brokerage Motilal Oswal Securities Ltd, the year-on-year (y-o-y) change in revenues for companies on the benchmark Sensex index on the Bombay Stock Exchange (BSE) has been a mere 3.4%. For BSE 500 non-financial companies, sales growth in the September quarter was in fact lower by 9.5% y-o-y. So there’s a disconnect between corporate numbers and the macro data.

The difference between production and sales data could be on account of inventories. But the Q2 GDP numbers show that inventory has actually declined. Another reason why the GDP data is far better could be the strength of government spending. Or, it could be lower prices of finished goods, compared with the year-ago period.

But even if demand improves, the same may not be true of earnings. Net profit growth for the Sensex companies in the September quarter was minus 2.7% y-o-y. The spate of earnings upgrades has slowed. There are concerns about the impact on companies once the effect of the stimulus dissipates. There are worries about the Reserve Bank of India tightening liquidity. And as the economy improves, raw material prices are likely to go up, squeezing operating margins of companies.

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Nevertheless, it’s true that in every recovery the markets run ahead of earnings growth and the latter catches up slowly. Take a look at the past price-earnings (P-E) multiple for the Sensex at the time the market started to recover in 2003-04. In July 2003, the Sensex traded at a trailing P-E of 14.7. This multiple went up steadily as the market improved, to 19.3 by January 2004. By May 2005, as the economy improved and earnings got better, the trailing P-E multiple for the Sensex dropped to 14.9 before moving up again. Seen from that perspective, the current Sensex past multiple of around 21.2 should also drop once earnings start catching up, though opinion is divided on how soon that earnings expansion will take place.

Anecdotal evidence indicates that while foreign fund managers are relatively bullish on India, local money managers are far less sanguine. They point to high valuations, the rapid ascent of the market, the huge amount of new issues and qualified institutional placements. A chief executive officer (CEO) of a well-known fund told me this difference of perception is mainly because when the foreign fund managers come to India, they compare conditions here with those in the US or Europe, and are consequently much impressed. It is this comparatively better performance that is responsible for fund flows to our shores.

GDP as well as growth in corporate earnings, in spite of all the concerns, should be relatively well supported. Our markets, however, are dependent on foreign inflows and a robust domestic economy may not be enough. Everything depends on conditions in the West. The events of 2008 have painfully driven home the point that markets are closely correlated. Recall that the story doing the rounds in late 2007 was that while the West may be laid low by the crisis, countries such as India and China will prove resilient and so money flows to these countries would continue. That belief proved to be very short-lived.

But isn’t it natural for the money to flow where the growth is? As the CEO pointed out, think of an investor in the West who has put his money into an exchange-traded fund that bets on emerging markets. If there’s a double dip in the economy in his country and the markets fall, is it likely that he will increase his allocation to emerging markets to compensate? Or is he likely to seek safety instead? That is why, while our economy may do relatively well, our markets will still be dependent on what happens to the economies of the West.

So, what are the chances of a double dip in the US?

There are plenty of unresolved issues from the previous boom that are still festering. One of them could be the commercial property market in the US. Another could be the end of the huge investment boom in China. Banks in Europe still need lots of capital. The recovery in the West has so far been a phantom recovery, pushed by vast amounts of liquidity and fiscal stimulus.

What happens when the stimulus is withdrawn? Will Europe take kindly to the falling US dollar, or will it lead to protectionism? It may be Dubai today, something much bigger tomorrow. Nobody knows for sure how all these issues will turn out. And if the momentum in the Western economies flags, the truth is that this time their central banks have no ammunition left.

Riding the wave of liquidity has yielded handsome returns so far, but it’s a dangerous sport and you have to keep a wary eye out for the tsunami. Small reversals like a Dubai default could lead to opportunities for buying on dips, but keep your eyes peeled for trouble. It’s best to watch the VIX, the US dollar index, the Libor/OIS spreads, the Ted spreads and other stress indicators very closely.

Manas Chakravarty takes a weekly look at trends and issues in the financial markets. Your comments are welcome at