The Hindu Business Line : Global markets play piper to Indian stocks

As a stock market investor, are you keeping tabs on signals from the US Federal Reserve, trends in the Japanese economy, or political developments in Thailand? If not, it is probably time you did. With the Indian stock market strongly outpacing those in other parts of the world over the past five years, we are often lulled into the belief that Indian market is resilient to global upheavals. But an analysis of stock market trends over the past ten years suggests the reverse may be true.

The relationship between the Indian stock market and its global counterparts has strengthened significantly in recent years. It may be increasingly important, even for long-term investors (and not merely traders who take positions for the day), to factor global market events into their investment decisions. A statistical analysis of monthly returns between the indices for India and various global markets drawn from the MSCI basket over a 10-year period clearly reveals a strong link between global and domestic market returns.

Global Linkages On The Rise

Global linkages for Indian stocks have been on the rise since 2002-03, when foreign institutional investments began to gain traction. In the five years before 2002, the Indian market (represented by the MSCI India Index) shared a relatively low correlation of 0.34 with the global market (represented by the MSCI All-Countries World Index). This indicates that the two indices did not move in the same direction very often. Over the next five years, however, the correlation has climbed to 0.49, suggesting a strengthening relationship between the two. The past two years have seen a significant increase in the global influence on Indian stocks, with a high correlation of over 0.80 between India and the rest of the world. The trends do not change materially, if the Nifty index is substituted for the MSCI India Index.

Returns on Indian stocks have, no doubt, been vastly superior to most other markets over the past five years. The MSCI India Index has registered a threefold rise from its levels in 2002, while the MSCI AC World Index has appreciated just 50 per cent. Most investors interpret this as a signal that the Indian equity market has broken away from global influences over the past few years. However, the rising correlation between the two indices suggests that the direction in which Indian stocks move is strongly related to trends in global equities. This suggests that, for the party in the Indian stock market to continue, equities as an asset class may have to continue to perform well across the world.

Vulnerability to Downside

If you are a conservative investor, there's another bit of disturbing news too. Indian stocks have been more responsive to global trends during the bear phases rather than the bull phases. For instance, the correlation between the Indian and global markets was much higher in the March 2000-September 2001 period (the bear phase triggered by the technology stock crash), than in the subsequent recovery (September 2002 to March 2004).

Similar trends played out in 2006 as well, with the domestic market declining in tune with global trends during the corrective episodes in May-June 2006 and in September-December 2006. This can probably be explained by the logic that the best-performing stocks (and markets), and not necessarily the fundamentally weak ones, are often the most vulnerable to profit-taking during a corrective phase, as investors (FIIs, too) rush to take money off the table.

In fact, the magnitude of decline in the Indian index during the corrective phases over the past couple of years has been far sharper than in the global bourses. The MSCI India Index lost 7.2 per cent on May 18 during the commodity price meltdown, while the MSCI World Index lost just 1 per cent.

Events such as the Thailand military coup (September 19) and the Thai government's decision to impose curbs on foreign investments (December 19) also sparked a sharper decline in the Indian market than in its global counterparts. This suggests that investors in Indian stocks should not expect to remain immune, if global events trigger a significant correction.

Mid- Versus Large-caps

Can you tone down the global influences on your equity portfolio by holding more mid- and small-cap stocks? The answer appears to be in the negative.

Over the past five years, mid-cap stocks, represented by the CNX Midcap Index, displayed a stronger correlation with the MSCI AC World Index than the large-caps, as reflected by the CNX Nifty index. They also suffered sharper reversals than the large-caps. This can probably be explained by the higher sensitivity of small- and mid-cap stock prices to liquidity levels in the market which, in turn, are influenced by FII flow patterns.

Given the higher risks involved, mid and small-cap stocks generally tend to find fewer takers during periods of market uncertainty. The lack of trading volumes in such stocks can magnify price declines.

Which Global Markets?

If you were to track the global stock markets, which are the specific regions you should monitor most closely for cues relating to India? Predictably, the emerging markets pack boasts the strongest long-term relationship with the Indian market. India's correlation with the MSCI Emerging Markets Index (at 0.64) has been much stronger than that with the MSCI World Index (0.49) over the past five years.

This is not surprising, given that FII flows into India are partly a function of overall allocations to the emerging markets. India's correlation with emerging markets such as Thailand and South Korea appears to be on the wane, while that with developed markets such as the US and Japan has been on the rise.

On a year-to-year basis, India's correlation with the US markets has registered a sharp increase from a relatively insignificant 0.13 in 2004 to a high 0.90 by 2006, while that with Japan moved from 0.26 to 0.75 over the same period. Greater responsiveness to gyrations in the US and Japanese markets may stem from the fact that interest rate changes in these two markets have had significant implications for global liquidity flows over the past couple of years.

While a two-year period is too short for conclusions on this score, investors could keep tabs on continuing trends to gauge if Indian stock prices will increasingly reflect movements in the US and Japan.

Finally, which are the key global developments that Indian investors should watch for cues on their investments? Well, here are a few that have exercised a significant influence in the recent past:

Signals on interest rates and rate changes in the US and Japan; higher rates are perceived as negative for stocks.

Movements in global crude oil and metals prices; higher prices help commodity stocks but dampen industrials

Local currency movements vis a vis the dollar; a weak currency means lower portfolio returns for foreign investors

Political or regulatory developments in other emerging markets; these impact the risk perceptions of global investors in relation to the emerging markets.

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