If you talk to most investors, you will find them a disgruntled and frustrated lot, which is surprising given that Indian financial markets are having the time of their lives, or so it is commonly perceived.

If you were to read the general papers, you would also think that we are in the midst of a huge bull market, and for most new investors the biggest worry about India is a feeling of the markets being highly overextended. They feel they have missed the run.

While it is true that the markets have had a dream run since 2003, rising by 370 per cent, the performance of the last 12 months has been very different from the three years prior to that.

Rising from a level of deep undervaluation and investor scepticism, the first three years of the bull run were a time of broad market participation and the market seemed like a rising tide that lifts all boats. The last 12 months have been quite different.

The Sensex is up only about 11 per cent in rupee terms over the last 12 months, with the MSCI-India index up about 23 per cent in dollars and 13 per cent in rupees. So global investors have benefited from rupee appreciation, and got much higher returns than the locals.

While the headline performance numbers mentioned above are decent and competitive, they hide the extremely weak breadth of returns.

As a recent strategy report published by Morgan Stanley in India (dated May 15, 2007) highlights, while the Sensex may have given us returns of about 10-11 per cent over the past 12 months, this entire return is due to only five stocks.

Reliance Industries, Bharti, Infosys, Reliance Communications and ICICI Bank have accounted for approximately 130 per cent of the Sensex return of the past 12 months, implying that if you did not own these five stocks but everything else in the Sensex, then you would have had a negative return.

It was not always like this markets have not always been so narrow, as between 2003 and 2006, the top five performing stocks in the Sensex accounted for about 50 per cent of the index performance (source: Morgan Stanley).

This phenomenon is not restricted to the Sensex, but actually gets even worse as you look at a broader basket of stocks. Morgan Stanley has highlighted in its report that the median return of the market over the last 12 months is actually -17 per cent.

They have looked at a basket of 2,389 stocks that actually traded over the past 12 months, and pointed out that 67 per cent of these stocks actually delivered a negative return, and while the median return of this entire universe is -17 per cent, the median return of the 67 per cent of stocks which declined was -30 per cent. Now this hardly seems like a raging bull market, does it?

Two out of every three stocks that traded over the past year are actually down, and that too quite significantly.

The above statistics highlight just how difficult it has been to make money over the past 12 months and also why most funds have found the going so treacherous. It is understandable why the majority of funds have found it so difficult to beat the market.

Either you were in the five stocks highlighted above, or most likely you have underperformed and not made money.

Now what are the implications of such a narrow market? The positive spin to this is that we are undergoing a natural corrective process, and that the market, reacting to the interest rate hikes, is gradually de-rating in terms of PE multiples.
While the markets may have been over-exuberant last May (when mid and small caps were in full bloom), this is now getting naturally ironed out and prices are taking a breather while earnings catch up. A decline in trading volumes also indicates that retail participation today is far less than 12 months ago.

Taken in this light, the last 12 months have been a very healthy pause that will refresh. It also questions the view of the bears who are constantly worried about market excesses. If the majority of traded stocks are down, how can the market be over-exuberant? As to how long this consolidation phase goes on is unclear, but at some stage the de-rating process will stop.

The negative view is that we are seeing the last stage of the market rally, wherein the breadth has narrowed dramatically and soon even the narrow indices and top 4-5 stocks will cave in and follow the broader market down.

This camp points to the narrow breadth as a sign of weakness and not a reason to be less concerned on the market.

While I don't think this narrow breadth is a precursor to markets collapsing, I think this corrective phase will continue for some more time as investors need to figure out the impact on both earnings and growth of a tighter monetary environment.

The longer-term impact of the rupee is another variable investors need to deal with. The huge pipeline of capital raisings is also a concern to my mind. We should expect to see at least Rs 50,000 crore (Rs 500 billion) of equity fund raising in the next 6-9 months; yet no one seems to be worried.

The average investor has not made money in the past 12 months, most funds have underperformed and FII flows into the country are weak and significantly lower on a year-on-year basis, yet everyone is sure all issues will be subscribed.

While it is true that the quality of paper coming to the market is good and should get subscribed, where will the money come from? Will this quantum of fund raising not put pressure on markets?

The Indian markets are not as overextended as commonly perceived, and, except for a small group of mega caps, are already in correction mode. My own sense is that this corrective phase will extend and broaden, aided in part by the largest equity issuance pipeline I have ever seen.

The attempt over the last week is to try and broaden the market rally and get even the mid caps to participate, aided no doubt by investors of all hues recognising the narrow breadth of the rise.

Many investors are using strong global markets to try and force local investors to commit. While this may continue for some time it is unlikely to last.

A further period of consolidation awaits.