Last week was bad for the stock market. After reaching a new high of 8821.84 early on Wednesday, the Sensex pulled back dramatically, ending the week at 8491.56.

The immediate reason for the sell-off is pretty simple - Foreign Institutional Investors have been net sellers. And since it is FII money which has been driving the market up, any selling by them is bad news.

But why are FIIs selling?

• Is it a good time to buy gold?

It's not just India

The first thing to understand is that it's not just the Indian stock market that was affected last week.

Consider this: The S&P 500, a broad-based index of US stocks, lost 2.7% during the week, its biggest weekly drop since April.

The Nasdaq Composite Index, a US market index for technology stocks, lost 2.9%, again its biggest weekly loss since April.

Stocks dropped in Europe as well---market indices for UK, Germany [Images] and France [Images] ended the week in the red.

Japan's [Images] Nikkei index lost 2.25%, while Australia's benchmark index lost as much as 4.3% - its biggest weekly drop in four years.

Other emerging markets in Asia too fell.

• Use Options to make money

What spooked stock markets across the world?

It began with comments by US Federal Reserve (the US central bank) officials that inflation is on the rise in the US. That led analysts to infer that the US Fed will raise interest rates further in its next two meetings this year.

The Fed has already raised its benchmark Fed Funds rate (the rate at which it lends to other banks) to 3.75%, in a series of rate hikes.

That raised several concerns:

1. With interest rates going up, growth in the US would slow.

2. With borrowing becoming more expensive, hedge funds would be hit. These are funds which borrow money in the US at low interest rates to invest in emerging markets at higher returns.

3. Mortgage rates in the US would rise, and that could burst the current bubble in the US housing market.

Now let us look at these factors in detail.

• Buying shares? Understand the settlement cycle first

How does this affect us?

To understand why higher interest rates in the US are such a problem for emerging markets like India, consider how the global economy works at present.

Essentially, low interest rates in the US have led to a boom in housing.

Many individuals could take loans at low rates to buy homes.

Those with homes felt richer with the rise in house prices.

Since the property prices rose, many were able to raise money on their house property (loans against property).

People were able to refinance their mortgages at lower rates (take a fresh loan at a lower rate of interest).

Low interest rates also led to increased borrowing of all kinds, including more credit card debt and other loans.

With this money, the US consumer bought all kinds of goods and services, and much of these goods and services are produced in countries like China and India. So the US consumer has been the main engine for the world economy.

Now consider the other side of the equation.

What did countries like China do with the money earned from exporting to the US? They invested it back into US bonds. That extra demand for US bonds meant that the prices of bonds rose. As a result, their yields fell.

Yields on bonds move inversely to their price. For instance, suppose a bond of Rs 100 has an interest rate of 10%. Let's say demand for that bond increases. When demand increases, prices increase. If the price of the bond (trading in the debt segment of the stock exchange) goes up to Rs 110, the yield becomes 10/110 or 9.09%. Conversely, if the price of the bond falls to Rs 90, the yield goes up to 10/90 or 11.11%.

It is because countries like China have been ploughing back their money into the US that the yield of the US 10-year bond has not increased in spite of the series of rate hikes by the US Federal Reserve.

In other words, while the Fed has raised short-term interest rates, the long-term yields have not followed suit. This has enabled a virtuous circle of low interest rates, high consumption and strong emerging market exports to continue.

Another consequence of the low interest rates in the US has been that many speculators have borrowed cheaply and used the money to invest in other assets, such as emerging market stocks and bonds. This has driven up the price of these assets (as explained above).

Also, since yields and interest rates in the US are low, investors will move their money to be invested in places where returns are higher.

• How to select stocks

Why higher US interest rates are a problem

The worry is that if interest rates now increase too much, this circle will become a vicious one-----higher interest rates will lead to money flowing back to the US from emerging markets, consumption in the US will decline, world growth will slow, and stock markets across the world will decline, with emerging markets being particularly hard hit.

In 1994, a series of rate hikes by the Fed had led to money flowing out of emerging markets, and many bearish analysts have been warning of a repeat of that scenario ever since the Fed started to raise rates again from last year.

In fact, the plunge in the Indian market in May last year, attributed to the election results in which the NDA lost, was actually part of a meltdown in emerging market stocks due to fears of a Fed rate hike.

So far, these worries have been unfounded.

• Stocks are still a good bet

Will it be different this time?

One comfort is that the price of oil has also gone down, and commodity prices too have declined. This will remove some of the worries about higher inflation.

The second source of comfort is that the US long-term bond yield has still not reached the 4.5% level, which is seen by some analysts as a signal of danger.

Third, although housing prices have declined a bit in the US, there are no signs of any collapse.

• 5 ways to identify a good stock

India and the world

As the above analysis shows, what will happen to the Indian market is largely dependent on what happens to the global markets.

It also doesn't help that Indian stock prices are now very high, which means that international money could flow to other stock markets around the world where the stocks are priced more reasonably.

However, while FIIs may sell, local mutual funds have raised a lot of money, and that would be invested back to the market. Recall that in May, while FII flows were tepid, local mutual funds continued to buy, providing support to the market.

Nevertheless, last week's steep drop is a timely reminder to investors about the risks of investing at these high levels in the market, and the need for a great degree of caution.