****Insightful analysis of stock market surge since March 2009

Another Stock Market Bubble?

C. P. Chandrasekhar
September 14, 2009

India’s stock market recovery over the last six months is a bit too remarkable for comfort. From its March 9, 2009 level of 8,160, the Sensex at closing soared and nearly doubled to touch 16,184 on September 9, 2009. This is still (thankfully) well below the 20,870 peak the index closed at on September 1 2008, but is high enough to cheer the traders and rapid enough to encourage a speculative rush.

There are two noteworthy features of the close to one hundred per cent increase the index has registered in recent months. First, it occurs when the aftermath of the global crisis is still with us and the search for “green shoots and leaves” of recovery in the real economy is still on. Real fundamentals do not seem to warrant this remarkable recovery. Second, the speed with which this 100-percent rise has been delivered is dramatic even when compared with the boom years that preceded the 2008-09 crisis. The last time the Sensex moved between exactly similar positions it took a year and ten months to rise from the 8,000-plus level in early 2005 to the 16,000-plus level in late 2007. This time around it has traversed the same distance in just six months.

With firms just looking to exit from a recessionary phase, this rapid rise in stock prices cannot be justified by movements in sales and profits. In fact, as the Business Line noted in its editorial on September 9, 2009 [ http://www.thehindubusinessline.com/2009/09/09/stories/2009090950560800.htm ], the price earnings ratio of Sensex companies now stands at 21, which is much higher than an average of 17, which itself many would claim is on the high side. Those comfortable with the market’s rise would of course argue that investors, expecting a robust recovery, are implicitly factoring in future earnings trends, rather than relying on earnings figures that are the legacy of a recession.

That would be stretching the case. Once the next round of arrears has been paid, the once-for-all component in the stimulus that the Sixth Pay Commission’s recommendations provided would wane. With the deficit on the government’s budget expected to reach extremely high levels this fiscal, a cutback of government expenditure is likely. Further, exports are still doing badly and the global recovery is widely expected to be gradual and limited. That would limit the stimulus provided by India’s foreign trade. And, finally, a bad monsoon threatens to limit agricultural growth and accelerate inflation. This would dampen the recovery in multiple ways. Given these circumstances, excessive optimism with regard to corporate earnings is hardly justified. The change in perception from one in which India was a country that weathered the crisis well to one that sees India as set to boom once again is not grounded in fundamentals of any kind.

This implies that the current bull run can be explained only as the result of a speculative surge that recreates the very conditions that led to the collapse of the Sensex from its close to 21,000 peak of around two years ago. This surge appears to have followed a two stage process. In the first, investors who had held back or withdrawn from the market during the slump appear to have seen India as a good bet once expectations of a global recovery had set in. This triggered a flow of capital that set the Sensex rising. Second, given the search for investment avenues in a world once again awash with liquidity, this initial spurt in the index appears to have attracted more capital, triggering the current speculative boom in the market.

While these are possible proximate explanations of the transition from slump to boom, they in turn need explaining. In doing so, we have to take account of the fact that, as in the past, foreign investors have dominated stock market transactions and had an important role in triggering the current stock market boom. As compared to the net sales of equity to the tune of $11.97 billion by foreign institutional investors during crisis year 2008, they had made net purchases of equity worth $8.75 billion in the period till September 11 during 2009. According to the Securities and Exchange Board of India, net purchases were negative till February, but turned positive in March with the net purchases figure being high during April ($1.3 billion), May ($4.1 billion), July ($2.3 billion) and August ($1 billion).

It is not surprising that foreign institutional investors have returned to market. They need to make investments and profits to recoup losses suffered during the financial meltdown. And they have been helped in that effort by the large volumes of credit provided at extremely low interest rates by governments and central banks in the developed countries seeking to bail out fragile and failing financial firms. The credit crunch at the beginning of the crisis gave way to an environment awash with liquidity as governments and central bankers pumped money into the system.

Financial firms had to invest this money somewhere to turn losses into profit. Some was reinvested in government bonds, since governments were lending at rates lower than those at which they were borrowing. Some was invested in commodities markets, leading to a revival in some of those markets, especially oil. And some returned to the stock and bond markets, including those in the so-called emerging markets like India. Many of these bets, such as investments in government bonds, were completely safe. Others such as investments in commodities and equity were risky. But the very fact that money was rushing into these markets meant that prices would rise once again and ensure profits.

In the event, bets made by financial firms have come good, and most of them have begun declaring respectable profits and recording healthy stock market valuations.

It is to be expected that a country like India would receive a part of these new investments aimed at delivering profits to private players but financed at one remove by central banks and governments. However, India has received more than a fair share of these investments. One way to explain this would be to recognise the fact that India fared better during the recession period than many other developing counties and was therefore a preferred hedge for investors seeking investment destinations.

The other reason is the expectation fuelled by the return of the UPA to government, this time with a majority in Parliament and the repeated statements by its ministers that they intend to push ahead with the ever-unfinished agenda of economic liberalisation and “reform”. The UPA II government has, for example, made clear that disinvestment of equity in or privatisation of major public sector units is on the cards. That caps on foreign direct investment in a wide range of industries including insurance are to be relaxed. That public-private partnerships (in which the government absorbs the losses and the private sector skims the profits) are to be encouraged in infrastructural projects, with government lending to or guaranteeing private borrowing to finance private investments. That the tenure of tax concessions given to STPI units and units in SEZs are to be extended. And that corporate tax rates are likely to be reduced and capital gains taxes perhaps abolished.

All of this generates expectations that there are likely to be easy opportunities for profit delivered by an investor-friendly government in the near future, including for those who seek out these opportunities only to transfer them for profit soon thereafter. These opportunities, moreover, are not seen as dependent on a robust revival of growth, though some expect them to strengthen the recovery. In sum, whether intended or not, the signals emanating from the highest economic policy making quarters have helped talk up the Indian market, allowing equity prices to race ahead of earnings and fundamentals.

Once the speculative surge began, triggered by the inflow of large volumes of footloose global capital, Indian investors joined the game financed very often by the liquidity being pumped into the system by the Indian central bank. The net result is the current speculative boom that seems as much a bubble as the one that burst a few months back.

There are three conclusions that flow from this sequence of events. 

• The first is that using liquidity injection and credit expansion as the principal instrument to combat a downturn or recession amounts to creating a new bubble to replace the one that went bust. This is an error which is being made the world over, where the so-called stimulus involves injecting liquidity and cheap credit into the system rather than public spending to revive demand and alleviate distress.  
• The second is that so long as the rate of inflation in the prices of goods is in the comfort zone, central bankers stick to an easy money policy even if the evidence indicates that such policy is leading to unsustainable asset price inflation. It was this practice that led to the financial collapse triggered by the sub-prime mortgage crisis in the US.
•  Third, that governments in emerging markets like India have not learnt the lesson that when a global expansion in liquidity leads to a capital inflow surge into the country it does more harm than good, warranting controls on the excessive inflow of such capital.

Rather, goaded by financial interests and an interested media, the government treats the boom as a sign of economic good health rather than a sign of morbidity, and plans to liberalise capital controls even more. In the event, we seem to have engineered another speculative surge. The crisis, clearly, has not taught most policy makers any lessons.

Comments:
Well laid-out analysis presentation. In your analysis this surge is not at all based on fundamentals but through the liquidity injection the world over. You have not mentioned when this bubble could burst e.g. current PE all the way to 25? What would be the criteria, either local event or global event, for this bubble to burst/party to be over?

from: Ranga Srinivasan
Posted on: Sep 14, 2009 at 13:25 IST
If there is a bubble in the stock market and it bursts, it will be the speculators and the greedy common investors who will suffer. But while the bubble is being created by foreign investors everyone suffers because too much money gets pumped into the country's monetary system creating inflationary pressures which drive prices through the roof. The government and the opinion makers worry only about a burst but remain unconcerned when the bubble is being created. Bubble or no bubble, a stock market boom is always considered a feather in the cap of the government.

from: K.Vijayakumar
Posted on: Sep 15, 2009 at 01:30 IST
The article has covered most of the facts about the current happenings. But it did not consider a simple fact that Indian equity markets did not crash on their own. We never reduced our stock values because of internal reasons. If it had taken that into the analysis then the whole dimension of this analysis would have been changed. And yes there can be a crash if the PE moves over and above 25 in short term but we may consolidate and our companies will maintain their PE at around 21-23.

from: Deepan R
Posted on: Sep 15, 2009 at 14:06 IST
The government should keep a close watch on the FIIs who are taking stock markets to dizzying heights and then booking profits, leaving small investors with deep wounds to lick for a long time. By no account the rising stock prices can be taken as an indicator of prosperity of the economy. It may, sure it will, cause more harm than good to the economy. Any government which takes the rising stock market indices as signs of economic growth is bound to witness the people being pushed to the ills of inflation.

from: N S Shastri
Posted on: Sep 15, 2009 at 16:58 IST
The stock market level cant be considered as an indicator of improvement in economy.because agricultural sector is in trouble and it has large share ateleast in indian economy on which FIIs are betting on.

from: girish
Posted on: Sep 16, 2009 at 10:10 IST
Many companies cleaned up their balance sheets in the last year. This should lead to much higher earnings in the next two years. I feel that is also factored in the current bull run of sensex.

from: Kaushik
Posted on: Sep 16, 2009 at 19:24 IST
As Deepan pointed out the question of whether the current upward spiral is a bubble or simply a correction depends on how you see the original crash -as a panic reaction not justified by fundamentals or a bubble that went bust. Common sense tell us that the inflated property values, inflated stock markets and a world awash in cash were not normal by any sense of the term, so the earlier crash was a bubble-burst. Part of it could have been a panic effect but most of it was bubble. Which brings us to the current surge, which is yet another bubble this time financed not by greedy investors but by equally greedy govts keen on showing they have slayed the recession dragon.

from: Ganesh

Posted on: Sep 17, 2009 at 14:18 IST
Whenever there is a recovery in the Indian economy, foreign investors always played this game. They invest in bulk unless the shock market reaches an unbelievable peak, and then they suddenly withdraw. It is the poor investor whose hard earned money is put in the stock market not in billions or millions but in thousands, most often, their life-time savings. Yes, the government should keep a track of FIIs.

from: Umesh
Posted on: Sep 17, 2009 at 15:45 IST
A very informative piece indeed. I do agree with the point of impending bubble burst the author has made. We, Indians, in general, have a propensity to get excited with the outside results and seldom ponder over the process that goes into manifesting itself in the way it does. We should focus more on the intricacies of the matter and not just have a superficial perspective on things of such critical importance.

from: Subhash Jha
Posted on: Sep 18, 2009 at 21:25 IST
Everybody who watch NDTV Profit would have seen erstwhile Finance Minister saying that " FII money is hot money " But, why he or his successor have not taken any steps to curb its volatile inlows and outflows is a mystery. It is the Indian retail investor who is left to hold the baby after each bubble burst. They lose much more money in the subsequent fall than what they made in the preceding rally

from: Chockalingam
Posted on: Sep 18, 2009 at 21:51 IST
It is good to be proactive! I am a novice and this article makes a good reading.

from: G.L.N. Reddy
Posted on: Sep 21, 2009 at 09:38 IST
A very good article about the dynamics of our stock exchange.I am only watching this daily as I have put most of my retirement funds into various Mutual funds.
By the way, is the peak date mentioned not Jan 13 2008 instead of September 2008?

from: Shankar
Posted on: Sep 22, 2009 at 17:44 IST
The stock market improvement in India can be considered a short-term swing. The FII investors seem to divert their funds to India since the direction of U.S market is not yet fully known. Till the U.S market recovers, India or BRIC countries for that matter would be considered a safe-haven for the FII's.

from: Satish
Posted on: Oct 5, 2009 at 06:56 IST
You mention the bubble to burst, but I think this process, would take at least 3-4 years, and till then FII's will change their direction of investment to other markets, because by that time recession would have gone. So the bubble which keeps expanding will start contracting. Inflation problem will not occur. The stimulus packages given by the central banks are intended only for a short period. So as our banks stop those packages, the liquidity problem might also get solved.

from: Santosh
Posted on: Oct 8, 2009 at 11:41 IST
The virtual economy of which the Stock Markets are an index impacts only a small fraction of India's population. Stock market bubbles worry only the privileged few. What really matters is the real economy and stimulus spending is needed to keep up infrastructure development at a pace that prevents economic depression and loss of human resources. Krugman has pointed out that unthinking withdrawal of stimulus was precisely what led to the Great Depression of the 1930s. The Government must be wary of this possibility notwithstanding the sorrow that it might bring to some of the speculators on the bourses hoping to double their capital overnight.

from: Taffazull
Posted on: Oct 24, 2009 at 10:58 IST

http://beta.thehindu.com/opinion/op-ed/article19895.ece

Also read:


http://www.ft.com/cms/s/0/4ec41a1a-d616-11de-b80f-00144feabdc0.html?nclick_check=1
Germany warns US on market bubbles
By Ralph Atkins in Frankfurt
Published: November 20 2009 19:48 | Last updated: November 20 2009 19:48

Germany’s new finance minister has echoed Chinese warnings about the growing threat of fresh global asset price bubbles, fuelled by low US interest rates and a weak dollar.

Wolfgang Schäuble’s comments highlight official concern in Europe that the risk of further financial market turbulence has been exacerbated by the exceptional steps taken by central banks and governments to combat the crisis.