Makings of a bubble

The Sensex touched yet another milestone on Monday when it scaled the 20,000-point peak in intra-day trades "" a doubling of the level that prevailed 21 months ago. All the people who have been advising investors that Indian market valuations are rich, and that the market must be due for a correction or at best a period of stability, have been proved hopelessly wrong. Indeed, those who have stayed out of the market because they felt that prices had reached giddy levels have started feeling foolish about missing out on a quite incredible bull run, and even they have been rushing into the market in an effort to make up for lost opportunities. When people suspend judgement in this fashion and try to join the herd, the market has the makings of a bubble. The question is whether the bubble will get bigger before it ends the way all bubbles do.

The latest bout of buying was set off by the US Fed rate cut a few weeks ago, and investors have simply ignored the real meaning of the cut, which is that the Federal Reserve expects a US recession to materialise next year. Or, perhaps, the Fed view has prompted even more money to come into India, because an economy growing at 9 per cent must certainly promise better returns than one that may be sliding into a recession. What lends resilience to the Indian market is the fact that every time there is a negative development and prices take a dip, they bounce right back to an even higher level. There have been six instances of 500 point-plus overnight gains in the Sensex and four days of 500 point-plus losses in the past three months. As of now, negative news is a spur to reach for new heights!

It is not just India, the story is being repeated in other emerging markets too "" like Australia, Hong Kong, Korea and Taiwan, all of which have reached new highs. Hong Kong has the specific booster provided by new access to mainland Chinese money; indeed, some Chinese portfolio investment is believed to be headed India's way as well. Overall, the rally remains an FII-led story, with these institutional investors pumping in a record $17 billion so far this year, of which half has come in during the last two months. The ironic twist is that the Sebi crackdown on participatory notes may have contributed to the latest rally, because those holding the P-notes are unwilling to offload for fear that they will not be able to buy back into Indian stocks (on account of the 40 per cent ceiling imposed by Sebi on such P-notes).

But however much investors may have enjoyed the ride so far, the fact is that valuations seem stretched. The Sensex trades at a price-earnings multiple that is 23 times estimated FY08 earnings and 20 times FY09 earnings, which is not cheap by any yardstick other than those prevailing today in the Shanghai market. But then, global liquidity is also a fact of life, and there remains an as yet unmet appetite for Indian paper "" which is one reason why the rally has been large-cap driven. This indicates that investors are willing to pay a risk premium for the largest companies in the country, and are unwilling to risk losing money on the smaller companies, even if they are cheaper buys. Even in a momentum market, it would seem, there is stock selection going on.