Although the mere size and recent growth of the Indian equity market has attracted much academic research testing the market efficiency, little has been documented on whether investment in Indian stocks is meaningful for investors. The Indian stock market seems to be characterized by significant profitability, but it varies among different sectors in the economy.
What’s Inside?
The authors attempt to answer two questions that remain rather unexplored in the finance literature in regard to the historical performance of the Indian stock market: Have Indian stocks offered a profitable investment opportunity for equity investors in the last decade, and if so, are these profits equally distributed among different sectors of the economy? They find that the Indian market earns persistent profits but the levels are not uniform among the critical sectors of the economy. The highest returns are delivered by the informational technology (IT) sector and the lowest returns by the pharmaceuticals (pharma) sector.
How Is This Research Useful to Practitioners?
A decade of positive and significant cumulative returns has led to much investor attention on the Indian stock market. Broad market profitability, however, does not constitute sufficient motivation for active foreign fund managers to engage in considerable trades in a relatively new but growing market that is also characterized by frequent volatility. For such investors, the investment proposal should be corroborated with strategic industry allocations and well-defined trading rules for stock selection purposes at times when portfolio rebalancing is executed. The authors move in that direction and provide evidence of significant profits generated by standard momentum trading strategies applied to the six most important industries of the economy—banks, multinational corporations, IT, fast moving consumer goods, pharma, and energy. Altogether, those sectors account for 60% of the aggregate stock market capitalization.
They also show that returns vary with the sector, with the riskier IT sector ranking first and the pharma sector ranking last in terms of profitability. In this respect, an investor who undertakes momentum strategies may take a long position in top-ranked sectors and a short position in bottom-ranked sectors in the context of rebalancing fund allocations. Empirical results indicate that such long and short trading strategies do earn excess returns in relation to the market. Those returns can be augmented when investors take advantage of short-sales availability, which actually applies to the Indian stock market.
In pursuit of a justification for the variability of profitability among the sectors, the authors statistically show that lagged market returns may predict sector returns. This result is attributed to the delay with which sectors react to information contained in the broad stock market, which is linked to the slow information diffusion hypothesis.
How Did the Authors Conduct This Research?
The authors use a sample of 50 stocks listed on the National Stock Exchange of India (NSE) that represent the six largest sectors of the economy. To assess the performance of the sector portfolios from January 2001 to December 2012, the stocks are benchmarked to the market index of CNX Nifty.
Within each sector, winning and losing stocks are identified on a monthly basis according to three technical trading rules: short-run minus long-run rolling moving average returns, a pure momentum indicator on whether the current price is less than the price 9 or 12 months ago, and a filter rule that generates a buy (sell) signal whenever current return is more (less) than 110% of the average return 12 months ago. Because sector portfolios are rebalanced by equally going long on winners and short on losers, average portfolio returns across the three trading rules are calculated over one-, three- and six-month holding periods to evaluate sectorial profitability. Results are checked for robustness, and hypotheses are retested after the authors control for stock heterogeneity in terms of size, market-to-book valuation, and liquidity.
On a separate note, generalized least-squares regressions are used to examine any predictability power of lagged market movements on individual sector returns. Nevertheless, econometric checks applied to the estimation casts doubt on the seemingly significant regression results because of evidence of severe endogeneity and heteroskedasticity issues.
Abstractor’s Viewpoint
Finance literature has shown that technical traders who implement momentum or contrarian strategies in various market settings along with a wide set of holding periods are expected to attain more profits in nondeveloped markets, which are characterized by high volatility and the small presence of arbitrage-driven traders. In this respect, positive excess returns from momentum trading across and within sector portfolios that have been found for the Indian stock market are considered somewhat foreseeable. What remains to be explored by both academic researchers and professional traders is whether these profits can be sustained as the Indian stock market becomes more liquid and at the same time more exposed to international arbitrage.