Indian stock markets witnessed their worst week ever with the Sensex tumbling 1347 points in five trading sessions. Here is all you need to know.

Why this sudden fall?

Several reasons. For one, there is a change in the global investment climate. One of the primary triggers for foreign institutional investors to reallocate their funds from risky emerging markets to stable developed markets is the hike in US interest rates (currently at 5 per cent).

Analysts are expecting further hikes in US interest rates. So, hedge funds and FIIs have been big sellers in Indian equity this week. They have sold stocks worth Rs 3,676 crore (Rs 36.76 billion) in the last five days.

Chetan Sehgal, director-research, Templeton Emerging Markets group, attributes the current volatility to strong interlinkages between global bourses.

"There was a greater correlation among global markets on Tuesday. The presence of hedge funds across asset classes, along with increased global movement of capital, has increased event-related volatility. Issuance of derivatives with no physical link to underlying assets has also contributed to increased volatility," he says.

Sensex's rise and fall: Complete coverage

Volatility in commodities markets has also significantly affected equity markets. Metal prices at the London Metal Exchange have witnessed choppy trading throughout the week.

This contributed to bearishness on metal stocks in India, as well; the BSE Metal Index lost 22 per cent since Monday.

How long is this fall expected to continue?

Once the markets started falling, a technical correction in the derivatives segment perpetrated a larger fall. The 'cost of carry' of derivatives was very high in the first two weeks. This led to a huge arbitrage between cash and futures positions.

But as a reversal of sentiment set in this week, the cost of carry went into discount and triggered selling pressure in the cash market.

However, the fallout of this is that outstanding in the derivatives segment has fallen sharply, and this indicates that there is less speculative element in the market now and, perhaps, less volatility in the coming week. Open interest in the futures market has declined from Rs 44,000 crore (Rs 440 billion) on May 10 to Rs 31,000 crore (Rs 310 billion) on Friday.

"The F&O expiry was nearing and there were a lot of long positions in the market. But as the markets fell people could not fund their losses that led to the correction accelerating," said Sandeep Sabharwal, CIO-equity, Lotus India AMC.

While markets are expected to open in the positive on Monday, a certain timeframe for the fall is a difficult guess. Analysts are expecting the markets to continue to be choppy for a while till global liquidity and commodity prices settle in.

"Markets are likely to go down further. The short-term outlook is negative," says Andrew Holland, executive vice-president, DSP Merrill Lynch.

Can India escape the global meltdown?

The most likely answer is it's unlikely. With the speculated impending US rate hike, no country is likely to be spared.

"The Indian markets can't escape the change in the global climate, especially as Indian stock valuations are already on the high side relative to other markets," says Samir Arora, managing director, Helios Capital.

Will foreign investors sell more?

Market expectations are that foreign investors would continue to sell. In fact, a Merill Lynch survey of fund managers in the pacific rim region shows that these managers are more underweight in India than other emerging markets like Taiwan, Thailand and Korea and would continue to be so for the next 12 months.

"Thus far a number of long-only hedge funds were busy booking profits as valuations looked stretched. But now they have been replaced by momentum funds, which are rising on the weak sentiment," says Naresh Kothari, head-sales, Edelweiss Securities.

Can mutual funds lend support?

With FIIs turning sellers in the domestic bourses, it was believed that domestic mutual funds would step in and buy equity thereby preventing a further fall. However, the net uninvested corpus of mutual funds is only about Rs 10,000 crore (Rs 100 billion) now - not significant enough to ensure a strong pullback.

Also, mutual fund managers feel the need to go slow as conviction levels are already low and market sentiment is negative.

"Fund managers want to ensure reasonable cash positions to meet any redemption pressures that may arise if markets continue to be weak," says Manish Kanchan, CEO, Ambit Capital.

Is everything okay at home?

The fundamentals of the Indian economy are still very strong. Some analysts say that business environment and corporate earnings are still fine so far, and the economy could handle a little interest rate hike.

Some others feel that corporate earnings are set to grow at 12-15 per cent, down from around 25 per cent over the past four years.

Also, the view emerging suggests that rising domestic interest rates could also further affect corporate earnings, especially of companies in sectors that are highly capital-intensive.

What will drive markets in future?

The impending monsoons are a trigger the markets are likely to look forward to.

Though corporate earnings are increasingly getting delinked from the monsoons, it could still spur rural growth etc, according to analysts.

Liquidity would continue to be the real mover of the markets, although corporate results would continue to provide cues to the market. During this week, Tata Motors [Get Quote] and SBI [Get Quote] announced their results, which disappointed analysts.

So, what's the bottom?

The market has corrected about 15 per cent from the all-time high. Analysts are now predicting that value buying will begin and prop the market up. They see investors coming back to the market when the Sensex hits the 10,500 level.

"We cannot be certain that this is the bottom of the market. Another fall of 300-400 points is likely," says Shahina Mukadam, head-research, IDBI Capital Markets.

Then again, analysts do not exude much optimism either. "After the big-bang recovery mid-week, there was a lot of comfort as it was a grand display of continued momentum in the market.

But the fall in the last two days of the week has made investors completely jittery and one could expect selling on every rise," says Kunj Bansal, CIO, Religare. "At best, I expect markets to stagnate at current levels. The worst could be anyone's guess," adds Kanchan.

What should traders do now?

Given the rise in volatility, it may not be advisable to trade in stocks that lack liquidity. Trading in stocks, which do not find presence in the derivatives segment may be dangerous.

The reason is simple: derivatives give you an option to hedge your position, limiting your losses, in case the market goes against you.

Keep your trading positions about 30 per cent lower than what you can actually afford. This would greatly help in avoiding distress sale in case the regulators slap additional margins. For an investor, leveraged positions are completely avoidable.

"The biggest risk to an investor is if she is leveraged- if this leverage can be reduced she could easily handle this volatility," says Arora.

Time to go bottom-fishing?

Even after the precipitous fall, markets are not going cheap. "Bottom fishing is a psychological phenomenon since even after a fall in the market the prices in most cases will be higher than what they were a few weeks back," says Arora.

The Sensex is currently trading at a price multiples ratio of 19.5 based on trailing 12-month earnings; based on current year earnings, it is at 17 times earnings.

Not too expensive considering the April 2000 level of 34 P/E, but not cheap either. The ten-year benchmark government security is currently trading at an yield of 7.59 per cent. In comparison, the yield on corporate earnings (inverse of P/e) stands at 5.88, which means stock are not screaming buy at this point.

Which stocks to buy?

Metals and technology may be good ideas to watch out for. Any rally in the market in the near-term would be led by metal stocks, analysts say.

Metals stocks are relatively attractively valued compared to other sectors which provides some level of safety. Frontline stocks like Tata Steel [Get Quote], Strelite, Hindustan Zinc [Get Quote], Sail [Get Quote], JSW may be reasonable bets at this point though smaller steel stocks may be avoidable given their vulnerability to cycles.

"The domestic demand is still strong and metals stocks are good value buys," says Amitabh Chakraborthy, head of research, Brics Securities - PCG.

Another segment, one may consider is technology. There are several positives. Foremost, if the rupee weakens further due to the changing global environment, it will act as a major trigger for tech companies, which largely have dollar earnings. Plus all front-line companies have posted good results this year and the earnings guidance by top players is bullish.

Technology remains insulated from risks arising out of monsoon, rising interest rates etc. Since this sector has been an under invested sector in the past year, analysts say, some institutional buying may emerge.

Some other value buys may be oil exploration major ONGC [Get Quote] which offers decent dividend yield plus may be a gainer net-net even if share a higher subsidy burden. Reliance Communications [Get Quote], which quotes at a significant discount to leader Bharti, may be another buy candidate.

Which stocks to avoid?

Conceptually, leverages companies may be avoidable. Uncertainty prevails on the future of oil marketing companies, hence it may not be time to enter these counters yet.

Relatively expensive stocks in the pharma space including the top three - Ranbaxy [Get Quote], Dr Reddy's and Cipla - may be avoidable, according to Nandan Chakraborty, head of research, Enam Securities.

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