Fast track

Fast track

Is there a contradiction between the Reserve Bank of India’s (RBI) attempt to tighten monetary policy and the recent rise in the Sensex? After all, if the central bank wants to slow the economy, shouldn’t that lead to a less bullish outlook for equities?

There are several answers to these questions. To start with, the Indian markets have been one of the worst performing this year, going up less than 4%. Further, the Sensex would not be the best barometer of overall performance—a broader measure such as the Bombay Stock Exchange small cap index is still well off the highs it reached in February 2007.

Unlike in China, there are no stories of people mortgaging houses to punt in stocks, or of pensioners playing the market. These are the classic symptoms of the final stages of a bubble. Alan Greenspan warned investors on Thursday that Chinese stocks might be in for a “dramatic contraction".

Despite occasional market dips, there are few signs that the Indian market is in bubble territory.

The composition of the recent rally is instructive. It has been led by banking and real estate stocks, which are interest-rate sensitive. The explanation is simple: The rally started after RBI’s monetary policy statement in April, which was widely seen to be less hawkish than the central bank’s previous utterances.

With the rate of inflation coming down, the view in the market is that RBI is almost near the top of its tightening cycle. That’s the reason bank stocks are back in favour. Robust earnings growth in the March quarter has also supported the market.

It may be wrong, however, to search for clues to the market optimism in the domestic economy. Markets across the world have been at new peaks recently, including the Dow. Within the region, stock market indices in China, Singapore, South Korea, Indonesia and the Philippines have also risen to new highs. That shows the surge in the markets is the result of global liquidity rather than domestic factors. Throughout the current bull run, pundits have focused on liquidity as the explanation for the rally, but they have been unable to agree on its cause. Some blame the excess liquidity on profligate central bankers, others point their fingers at the “carry trade", while many offer structural explanations such as a glut of global savings or the benign impact of globalization.

Whatever be the reason, it’s unlikely to disappear overnight, although there are bound to be nasty shocks, the last of which occurred in February. This time, too, there have been plenty of warnings that the Chinese stock market is overheated and heading for a crash—a crash that will inevitably pull down other markets, too.

RBI is keen to slow the economy, it still estimates GDP growth to be 8.5% this fiscal. That implies a growth rate in the low double-digits, for both industry and services. Factoring in inflation, average earnings growth of around 17% is likely this fiscal. While the growth rate is commendable, the problem is that the markets have already factored that into stock prices, which is why the price-to-earnings ratio for the Sensex is so high.

Why then is foreign investment pouring into the Indian market? The weakening dollar could be one reason, as it makes non-dollar assets more attractive. The fact that the premium for the Indian market has diminished in recent times is also a factor. And lastly, there’s little doubt that local punters have climbed on to the bandwagon, as seen from the higher open interest in the futures segment. Of course, the underlying strength of the economy also cushions the downside.

But, while appreciating the attractions of the long-term India story, investors will do well to remember that the business cycle is not dead and that markets are prone to overshoot in both directions.

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