Are Indian stock markets 'scary'?

Indian stock markets have been on a roller coaster ride lately. After plunging to sub-18,000 levels during the latter half of August 2013, the benchmark BSE-Sensex is back close to 20,000 levels. From the very bottom to the very top, it's a neat 12% rise in a short span!

Many have attributed the bounce back to the new RBI Governor, Raghuram Rajan. The rupee has also gained about 8% from the recent all-time lows.

How should you read this recent spurt in stock markets? In fact, that's a wrong question. The question should rather be- should you read too much into the recent optimism?

Our answer is no. For one, the 'Raghuram Rajan' effect has been overhyped. We respect him for his talent and the initiatives that he has announced. But to believe that India's long term problems have been addressed would be nothing short of wishful thinking.

Secondly, there has been some seemingly short term relief on certain external fronts. And the markets have found enough reason to cheer.

But does that mean India is out of trouble? If Jeffery Gundlach, a widely respected bond guru is to be believed, the outlook for Indian stock markets is negative. He thinks Indian markets are "very scary" in the medium term. Why so?

The answer is the risk of capital outflows. As you know, Indian stock markets are heavily driven by foreign capital flows. So anything that may cause foreign institutional investors (FIIs) to exit Indian stocks could bring Indian stocks tumbling. One big factor is any change in the monetary policy of major central banks. The US Fed had hinted about a likely tapering in its QE program starting September. If that happens, it could trigger a mass exodus of capital from emerging markets. And India would be among the worst affected.

A point to be noted here is that India has been a big beneficiary of the ultra-easy monetary policies of developed economies, especially the US. And hence the risk of capital flight in the case of change in monetary policy.

The point we want to drive across is that India is very vulnerable to external shocks. Any negative trigger could put the recent stock rally in reverse gear.

But this does not mean you keep away from Indian stocks. In fact, a market meltdown triggered by capital flight would be a great time to lay your hands on fundamentally sound stocks. For disciplined value investors, market meltdowns are always very exciting times. Because that's when there's too much fear and people are dumping stocks out of panic.