A P: The Old versus the New

Having effectively doubled over the past 24 months, the markets are due for a breather.

Given where markets are today, one is seeing a healthy debate emerge on the direction of the stock markets. On one side you have the old hands, who have been investing in India for years, and feel they have seen it all; stacked up against them are the new kids on the block, typically new to India, having been involved with the Indian markets for at most 12-18 months.

The old hands are universally cautious, and have been net sellers in this last move of 800 points on the Sensex. The old guys are convinced that the markets are now in a euphoria zone, and that valuations are no longer defendable, with the markets at 15-16 times 03/06 earnings.

Having bought stock at much lower levels, there is also a fundamental sense of unease in having to buy the same stocks at 5-6 times the level of initial purchase.

The older guys, having typically participated in this market rise since inception (March 2003), are sitting on very healthy profits, and are acutely conscious of the fact that nothing goes up forever in a straight line (neither markets nor corporate earnings).

The veterans are also very worried about the contours of the incremental flows into India. Money sourced from Japanese retail investors, Korea and Taiwan does not lend great confidence.

Do these investors really understand India, do they really need to be in our markets? These seemingly naïve investors have put $2.5 billion into the markets over the last three months. To the veterans this just seems like momentum chasing at its worst.

The veterans are also disturbed by the market's unwillingness to even contemplate negative news. If an election were to be held today there is a reasonable chance that a third front government will be formed.

Is that possibility in anyone's calculations? What has this government really delivered in terms of progress on economic reforms?

If trying to get approval to sell a further 10 per cent in Bhel is seen to be such a gigantic task, what hope is there of this government tackling anything remotely difficult?

Many of the old-timers feel this government lucked out in inheriting a strong economy, and have little confidence that the UPA coalition will be able to sustain 7 per cent GDP growth.

As for the new guys, the typical profile here is someone working at a hedge fund or new to the long-only side. This investor base has seen India for the past 12-18 months at most, when by and large markets have been heading up.

Having made money they have great confidence in their own abilities, and the long-term bull case for India. Not having seen the valuations, the Indian markets and specific stocks traded at for most of the 1990s, in fact till 2003, they have less heartburn buying Bharti at 300 or Tata Motors at 500.

These new investment gurus still find the market and individual stocks cheap, and wonder why the old-timers are so nervous. Why are 15x 03/06 earnings expensive for a market growing at 20 per cent plus, with interest rates at 6-7 per cent?

Don't bull markets always climb a wall of worry they ask? They will also argue that while India has done well over the past 24 months, it is by no means an exception.

The whole emerging markets asset class has done well and there are other large markets which have done as well as India, if not better. Take Korea in 2005 as an example.

The new investor also argues that what we are seeing in India is the beginning of a multi-year bull cycle, taking the 18-year bull run of the US between 1982 and 2000, as their template.

Valuations will never again go back to the artificially depressed levels of pre-March 2003, and therefore there is no point in using those multiples as a base to compare current stock prices.

The new guys also are less worried about the massive flows from Japanese retail investors and the like as they argue that India is still in a discovery phase with many investors still to participate.

They also mutter secretly about the next billion dollar India fund being raised in the Gulf or wherever, to justify their point that flows into India show no signs of receding anytime soon.

As is normal in situations like this, both sides have valid arguments and the truth will normally lie somewhere in between. I agree with the new guys that it is unlikely that valuations will drop back to the 2003 levels, and it is pointless feeling nervous about a stock just because it has tripled, focus on the current valuations and prospects today, forget about where the stock was 18 months ago.

I also agree that India is a long-term bull story, and flows may remain strong for some more time. However, where I disagree with the new guys is in their lack of worry about the progress on economic reforms, as progress here to my mind is still important to sustain the 7 per cent GDP growth that underpins current earnings growth expectations.

I also worry about the source of the incremental flows into Indian equities. There is a huge chunk of momentum money in the markets currently, which will reverse at the first signs of trouble.

While I believe in the long-term story of India, no market goes up forever; having effectively doubled over the past 24 months, the markets are due for a breather.

When you have the inevitable correction or a period of sideways movement, it will be interesting to see how long-term all the recent flows into India really are?

While in the short term the money on the margin is being invested by the new guys, and thus they will control the direction and pace of market movements, their grip will not last forever.

Most of the veterans are fund managers at large long-only investment houses, who are currently finding it difficult to be dramatically underweight India (given the momentum).

But let the market show any signs of weakness and I think one will see a deluge of selling from these guys, as they are fundamentally fully invested bears.

Be prepared for a period of range-bound markets over the coming months; this momentum is unsustainable.