A brief shock

While the Sensex's quick pull-back from a sharp drop of over 200 points on Wednesday may be an affirmation of the strength of this market, it's important to remember that market breadth remains negative, and even the Sensex has more losers than gainers.

Everybody agrees that a correction is overdue, that the market has gone up too far too fast. The last 500-point rise in the Sensex, for instance, happened in just eight trading sessions.

While there is no doubt that buying by both foreign and domestic funds had much to do with the rally, the sharp rise in the small cap index indicated that local speculators too had become active.

Moreover, market observers have for long been calling attention to the inflow of large amounts of money into portfolio management schemes, which have also played its part in boosting small- and mid-cap stocks. Wednesday's fall in the small- and mid-cap stocks, therefore, is to be welcomed.

Valuations in some of these stocks have risen well above rational levels, and the market regulator's initiative in imposing lower ceilings and higher margins on them is the right response to curb the exuberance.

However, as the bounce in the Sensex shows, even at the current high valuations there is demand for some frontline stocks. What's more, the pullback in the Sensex occurred in spite of the 25-basis-point rise in the US Federal Funds Rate, and a rise in international crude prices. Clearly, this is a classical bull market that ignores all bad news.

It's also a market that has defied predictions of doom and gloom for over a year now. It has weathered the rise in the US Fed Funds rate from a low of 1 per cent to the current 3.75 per cent, it has been propelled upwards in spite of what increasingly looks like a political gridlock on reforms, it has been dismissive of all talk of global imbalances, it has ignored the increase in oil prices, and it has thrived in spite of a strengthening dollar.

Instead, the Indian stock market, together with most other emerging markets, has been pushed up on a flood of liquidity that has spilled over from easy US monetary and fiscal policies, on the one hand, and an unprecedented build-up of foreign exchange reserves in the Asian economies and recycled into the US markets, on the other.

The impact of this liquidity can best be seen in Alan Greenspan's "conundrum"""the fact that long-term interest rates in the US are around the level they were a year ago, in spite of a sharp rise in short-term rates.

The big question is whether the party can continue. There's little doubt that, at current levels, the risk-reward ratio has worsened considerably. There's a lot of froth in the markets, especially at the mid-cap and small-cap levels. But the key to this market lies in the flow of liquidity.

Mutual fund data and the anecdotal evidence of investments by high-net worth individuals indicate that domestic money is now reinforcing the inflow of foreign funds.

The Indian markets are being discovered by funds from Japan and Korea. And so long as the Goldilocks (not too hot, not too cold) economy lasts in the US, fund flows to emerging markets are likely to continue.

The concern is whether the Indian market is now over-valued compared to its peers. The second quarter corporate results will soon answer that question.