It has caused a little pain but the 10 per cent fall in India's bellwether stock indices in the first two months of 2011 is no cause for worry. Market conditions just before this decline were beginning to resemble the euphoric days of 2008, with a certain smug complacency about the India story, frothy market valuations and exuberant action in small-cap stocks. Some of that froth has been blown away, ensuring better long-term returns for retail investors who choose to join the bull market at this juncture.

Thanks to this correction, market valuations have gone from being extremely demanding to realistic. The Sensex price-earnings ratio has moved from a high 24 in December 2010 to 19, and close to its long-term average of 18. Meeting the growth expectations embedded in the December valuation would have been quite a tall order for India Inc. While any PE multiple can be justified in a growing economy through fancy profit projections, the truth is that volatile commodity prices, a fluid global scenario and whimsical government policies make for limited predictability in India Inc's earnings beyond a year or two. That risks to profits can crop up from unexpected quarters is borne out by the recent upward spiral in global prices of commodity inputs from crude oil to packaging material. Stubbornly high inflation, which is pressuring the RBI to let go of its easy money policy, too poses a risk to sectors such as infrastructure, capital goods and realty that have large capital requirements. Topping this off is recent economic data showing a moderation in manufacturing output. While these risks may merit a downgrade of earnings estimates, stock prices in several sectors seem to have corrected to account for that.

The one disturbing aspect of this market decline is the exceptional volatility that accompanied it — a reflection of poor market depth. Intra-day swings of 6-7 per cent in index stocks and the 30-40 per cent declines in quality mid-cap stocks over a month indicate the extent to which the Indian market relies on Foreign Institutional Investors, not only for direction but also for liquidity. Net FII pullouts of a mere Rs 7,100 crore over a month are not a big deal; yet they wiped out Rs 7 lakh crore of investor wealth! The market regulator may have a role to play here. If domestic institutions have been missing in action for almost two years now and not been the counterpoise, it is largely because inflows into mutual funds and market-linked insurance plans have dwindled sharply. This, in turn, is because their agent force has dwindled after the regulatory crack-down on commissions on these products. Disciplining intermediaries is necessary for investor protection. However, SEBI must now ensure that retail investors who have the risk appetite to make long-term investments in equities are not denied access simply because the distribution industry is in disarray.

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