Beware of speculation-driven stocks in this rally

The equity market rally over the past 30 days has been led by speculative stocks rather than fundamentally sound stocks.

The performance of indices given in the tablebelowshows the sharp rally in sectors such as real estate and infrastructure, and the relative under-performance of the broad market (Nifty) to these sectors.

[caption id=“attachment_188472” align=“alignleft” width=“371” caption=“There has been a sharp rally in sectors such as real estate and infrastructure.”]  [/caption]

The performance of stocks in these sectors highlights the speculative nature of the rally. In the real estate index, stocks such as Anant Raj, HDIL and Unitech rallied by 47 percent, 37 percent and 33 percent, respectively. In contrast, the largest company in the sector, DLF, rallied just 6 percent.

Similarly in the Infra index, stocks such as Lanco, GMR and RCom allied between 35 percent and 55 percent, while far stronger infrastructure company stocks such as L&T and BHEL went up by around 20 percent each.

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Can the rally in speculative stocks be justified?

The fact that the Bank Nifty has rallied by 13 percent on the back of a fall in bond yields (the 10-year benchmark bond yields are down 50 basis points over the past two months) suggest that interest rates are expected to come down, leading to cheaper cost of funds for realty and infrastructure companies.

The rally in the Indian Rupee has improved sentiment on fund flows into risk assets. The rupee has rallied by close to 5 percent against the US dollar over the last fortnight.

Expectations of lower interest rates coupled with improved sentiments in FII flows has led to a sharp rally in stocks, especially speculative ones.

Fundamentally, nothing has changed for real estate or infrastructure companies.

Falling government bond yields has not and will not impact borrowing costs for indebted companies. Government bond yields are down due to the fact that the RBI is buying government bonds to support the market.

The rise in the rupee is also led by RBI sales of dollars and the central bank’s firm stance on currency speculation. On the other hand, despite RBI purchases of government bonds, liquidity in the system has tightened by over Rs 75,000 crore since September 2011 to date. Banks are borrowing over Rs 150,000 crore from the RBI on a daily basis.

Tight liquidity conditions will keep lending costs high as borrowing costs for banks have gone up by 50 basis points over the past two months, with CD (certificate of deposit) rates at 9.95 percent.

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The risk aversion of banks to real estate and infrastructure companies will continue as many companies start defaulting on loans.

Lanco has, in fact, defaulted on a power project loan this month. Loans to airlines will also have to be classified as non performing loans (NPAs) as airlines such as Kingfisher struggle to meet daily cash requirements.

The government is not going to spend more on infrastructure given its weak finances. It has also borrowed Rs 50,000 crore from the RBI to meet its requirements and given that it has upped it fiscal deficit forecast by 1 percent, it has no means to fund infrastructure spends.

The markets are pricing a sharp turnaround for speculative companies, and this is unwarranted given current business and fiscal environment.

The rise in the prices of speculative stocks in the real estate and infrastructure sectors should make investors cautious rather than bullish on markets.

Searching for more such stocks to make quick returns will prove to be disastrous.

Investors hoping to invest can invest in the index or in fundamentally sound stocks that do not require speculative action for their performance.

**Arjun Parthasarathy is the editor of ** www.investorsareidiots.com,a web site for investors.