The current run-up in the market has been so rapid that many would-be investors have the feeling of being left out. That’s probably a good thing, as it means there’s new money waiting to come into the market at every dip. But the worry that most investors have is whether valuations are too stretched at current levels. With the Sensex trading at a price-earnings multiple of more than 24, that’s a valid question.

The usual argument put forward by foreign institutional investors underweight on the Indian market is that it’s too expensive compared with other markets in Asia. The Sensex is the most expensive among Asian emerging markets after Shanghai, not only going by the historical P-E multiple, but also going by the forward P-E for the current year. But then, investors have known for years now that India is a more expensive market, and that hasn’t prevented them from pouring billions of dollars into it.

Perhaps it’s the relative price-earnings multiple, rather than the absolute level, that matters more. Seen from that perspective, the Sensex P-E has gone up from around 17.7 at the beginning of January 2005 to the current level of around 24.1. Over the same period, the Kospi P-E has gone up from 7.3 to 18.6; the Taiwan index from a P-E of 13.1 to 22.5; and Jakarta from 13.8 to 21.2. In other words, the P-E multiples of these markets have expanded by more than that for the Sensex. Only the Kuala Lumpur index has seen a much lower P-E expansion. Simply put, the premium in terms of P-E that the Indian market has always enjoyed has, in fact, come down.

But the argument is that since earnings growth for Indian corporates is coming down, P-Es too should be revised downwards. A look at Bloomberg’s P-E estimates for the Sensex based on forward earnings, however, shows that its premium over several Asian markets, such as Singapore, South Korea, Malaysia and Hong Kong, is much lower than the premium it enjoys when the P-E is computed on the basis of past earnings.

What’s more, if, as several analysts have been pointing out, the stage has been set for a bubble in emerging markets, then valuations are often thrown out of the window. During the tech bubble, the Sensex had a peak P-E of more than 29.

Divergent markets

The divergence between the stock market and the bond market seems to be increasing. Interest rate sensitive stocks have been moving up in recent times, with the BSE realty index up around 30% after 1 September. In contrast, the yield on the 10-year bond has remained at precisely the same level as it was on 18 September, before the US Fed cut its funds rate.

Is the stock market being too optimistic about an interest rate cut?

Perhaps the bet is that with foreign institutional investors pouring in funds into the market and with RBI unwilling to let the rupee appreciate, the resulting liquidity will be too much for the central bank to handle and interest rates will drift lower.

However, the bond markets show no signs of buying that argument. One reason, points out A. Prasanna, economist with ICICI Securities, is that RBI has sucked out a huge amount of money recently via market stabilization bonds. There are persistent rumours of a CRR hike, coupled with talk of a lower statutory liquidity ratio (SLR). With banks’ investment in SLR more or less at the statutory limit, any reduction will lead to securities being sold and yields going up.

“You can’t fight the central bank," says Gaurav Kapur, senior economist with ABN Amro Bank. He points to the high cost of crude oil and food and says RBI will be very sensitive in not letting inflation expectations get out of hand, especially when elections could be around the corner. The bond market has been wrong about RBI before and it doesn’t want to let its guard down again.

Is the stock market getting ahead of itself then? Not really—the exuberance in realty stocks is also a reflection of it being a hot new sector and of the amount of foreign money being invested into real estate. The performance of the other interest rate sensitive sector—autos—has been far more tepid. It is only now that the BSE auto index has been able to claw its way back to the levels it reached on 24 July, just before the credit crisis.

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