The Indian stock markets are seen scaling stratospheric levels in 2004.

DSP Merrill Lynch, one of India's leading investment banking and brokerage firms, is highly bullish on the Indian capital markets.

In its latest report, the investment banker says that the Sensex -- the Bombay Stock Exchange's 30-share sensitive index -- could touch 6500 levels by December 2004 due to stronger-than-expected flows from new FIIs and better performance by major companies.

DSP Merrill Lynch, however, cautions that the stock markets will be 'more volatile in 2004 and will most likely follow the seasonal patterns of normal years.'

Two rallies seen

The DSP ML report says there could be two big rallies on the bourses. The first during the early part of the New Year led by expectations of higher FII fund inflows. And the second rally is expected after the general elections as markets expect acceleration of reforms.

However, in the near-term, DSP Merrill Lynch is slightly wary about the consensus bullishness on the Indian stock markets. It says such bullishness makes the markets vulnerable to any bad news.

The report hints that contrary to popular opinion, this period may well be the peaking of the Indian stock markets as opposed to the start of a bull run.

Retail investors to return

The DSP ML report says that the small investor might be a major player in the Indian equity markets during 2004 due to two factors:

• The relative attractiveness of equities will rise further with the bond market peaking out following a flattening of interest rates; and
• There will be a significant change in the retail investors' portfolio, away from the debt funds, as debt becomes less attractive.

Strength under-estimated

The DSP ML analysis says that the strength of the foreign institutional investors' flows into the Indian stock markets had been largely under-estimated, especially inflows from new FIIs.

The investment banker feels that 'non-traditional Indian investors' will drive fund inflows into the stock markets in 2004.

Many investors in India, the DSP ML analysis says, were cautious on the markets at current levels and were not investing additional money after the sharp rally. But many new investors, who hitherto had no exposure to the Indian markets, have started pumping in fresh funds into the Indian bourses as they see long-term growth prospects here.

India is one of the biggest markets for global emerging market funds, and non-dedicated global investors are now likely to drive flows to the Indian markets.

The large global investors could buy the index heavyweight stocks, while retail investors may focus on the small-cap companies, the report says.

The brokerage expects 'returns in the equity markets in 2004 to be led by earnings growth rather than a valuation re-rating.'

Strong economic growth

Most investors believe that India is on a high economic growth path; most even accept that India had performed much better than most analysts had predicted.

On the back of strong monsoons, good pick-up in manufacturing activity, strong forex reserves, companies' stellar performance and increasing exports, the Indian economy is on the ascent and may well post a GDP growth rate of close to 7 per cent this year.

Most investors, says DSP ML, feel that corporate India's earnings growth are more realistic this time and may see an improvement due to the monsoon effect in the early part of 2004.

Some risks too

Yet, the DSP ML report says that there are some risks for the Indian economy too:

• A continued global economic slowdown could hit earnings.
• Any sharp rise in interest rates will hurt the economy as it will retard the consumption boom and slow down investment spending. However, DSP ML feels that the Reserve Bank of India will continue with its soft interest rate policy and might even infuse additional liquidity to meet better loan growth demand. A comfortable inflation environment and rising foreign exchange reserves will allow the RBI to keep the interest rates easy.
• With general elections round the corner, the report says there is a likelihood of the reforms pace slackening a bit, like it happens during the pre-election phase. However, the report says that the markets are always strong post-elections as reforms accelerate, irrespective of the nature of the government.
• If there is a lack of enough good quality public issues, the foreign and the retail investor may not be heavily attracted to the bourses.

But despite some analysts pronouncing the equity markets as 'overheated' and valuations as 'unrealistic,' the inflow of funds from FIIs into the Indian stock markets has remained very strong, with over $7 billion FII funds parked in India.