20% rally in 40 days: Is this a bull market!

After a rather depressing 2011, market appears to be on the path to recovery with a 20% jump so far in 2012. Typically it is time to take stock of the rally and ask the big question if it's just liquidity or has the fundamentals changed or if despite all the skepticism, we have slipped in quietly from a bear market into a bull market.

In a new show Bulls or Bears, CNBC-TV18's Udayan Mukherjee spoke to H Nemkumar, head of institutional equities at IIFL to understand if he thinks a fundamental trend change has happened. 

Below is an edited excerpt from an exclusive interview with H Nemkumar, head of institutional equities at IIFL. Also watch the accompanying video

Q: Your January report was very cautious while putting out that 2012 will be another difficult year for markets. Have you changed your view in the light of what has happened in the last 40 days?

A: No. When we had put out this strategy report, we were conscious of the fact that the markets had corrected significantly. Out of BSE 500, almost 30% of stocks were down more than 50%, but the problem was the stocks that corrected had a whole host of issues, either governance issues or cyclical issues or balance sheet issues. The companies that were in reasonably good shape had seen their  stocks doing  reasonably well and their valuations held up.

So, the dilemma that we had was that market had corrected significantly, valuations had contracted, but at the same time the macro cycle was bad, the economy was slowing down and the outlook for FY13 looked very challenging. We had seen deep earnings downgrades in FY12. In the last calendar year, of the 150 stocks that we cover, almost 36% of the stocks had more than 30% earnings downgrades. Outlook for commodities as well as banks, which have the largest weightage in earnings, were also very mixed.

The restructuring of exposure to infrastructure sector as well as the unpredictability in global commodity prices were the key factors that influenced our view.

Looking back as to what happened in the last 40 days, I think that this has been a massive liquidity driven rally. Nobody had anticipated that the price of risk would come off so quickly. Now I think markets are also pricing in that this large amount of capital flows would have a reflexive impact on growth. In the past, whenever India has had large capital flows we have seen growth picking up as well.

I think a lot of hope is getting built that post the UP elections, reform process will be kick started. The Budget would not be as bad and the reflexive impact of capital flows on future growth would be visible as we move forward. But I think there are still a lot of fault lines, savings as a percentage of GDP has sharply come down. ROEs are under pressure. Global commodity prices of course have picked up but we will have to wait and see the sustainability.

Therefore I still think that the risks to earnings remain. Of course on the positive side, we have seen inflation coming off and interest rates should also come off. But I think this Budget is going to be a very crucial one from that perspective because if fiscal deficit does not come off or is not within the manageable limits, then even the rate cuts may be much slower than everybody is expecting.

Q: Would you say that in summary it's too premature to say that a new bull market has started. You would use this 20% rally to come to that inference?

A: No. I think that clearly we had a very tentative start this year. It is all liquidity fuelled. A very large part of the flows have been ETF led. I would think  fundamentals have to fall in to place for us to have a real bull market.

Q: If you look back into the last few year multi bearish patches that India has gone through, we did see 30% plus rallies even within those bearish years. Would you like this rally to one more of those cyclical rallies in an otherwise bearish construct then?

A: Very possible. I think in the world in which we live in, there is so much of interconnectivity - Brazil is up as much as India. So emerging market funds have seen huge inflows and as I mentioned earlier it is more ETF led. This whole risk-on, risk-off and the speed with which the price of risk moves has a very big impact on flows. I would say that because India was such a oversold market.

We have seen a very sharp come back; it is possible that we could see this sustaining for some time to come.  But as I said before, for it to sustain beyond this, you have to see fundamental changes happening and the macro economic variables getting better.