Frothy waters

Frothy waters

It has taken three trading days for the Bombay Stock Exchange Sensex to zoom from 18,000 to 19,000. Even the most fervent bulls have been taken by surprise, not to mention sceptics like us.

The benchmark index is now 48% above its level a year ago. Given the rise of the rupee over the past year, foreign investors have earned an extra 10% from currency gains.

Finance minister P. Chidambaram has already said last week that the steep rise in equity prices both surprises and worries him. That was a timely warning. But moral suasion of this sort is unlikely to work when your neighbour at home or office announces that he has doubled his money in three months. Asian markets have been soaring because of the belief that the world economy has changed. That’s true—at least partly. The US is no longer the largest contributor to global growth. Its place has been taken by China. India, too, has emerged as a major contributor to global growth. So, Asia could be less affected by a US slowdown or recession than before.

There is speculation that the economies of Asia and America are “decoupling"—or going their own separate ways in the months ahead. That is a leap of faith. While there is little doubt that China, India and Asia play a far bigger role in the world economy today, most of the trade between them is still in intermediate goods. Final demand for cars, computers and other goodies still comes from the US. There is little evidence as yet that domestic demand in Asia will be strong enough to balance out a slowdown in US demand, as its housing bubble surely and slowly deflates.

Current valuations, too, appear stretched. The market is trading at more than 25 times historical earnings; the unwritten assumption here is that investors expect corporate profits to grow at this rate at least for the next three to five years.

It’s a tall order. Many brokerages are predicting a modest slowdown in corporate earnings in the July-September quarter. Profit growth could be well under 20%, against an average of 25% over the past nine quarters. Meanwhile, there are also some early signs of balance-sheet strains. Credit rating agency Crisil said last week that downgrades have exceeded upgrades for the first time in five years.

We have little doubt that the Indian economy is in the early phases of a long boom that could last a couple of decades. We are perhaps at the same point that Hong Kong and South Korea were at the end of the 1960s or Thailand a decade later. So it is natural to expect share prices to follow the economy in its upward journey. But there will be times when the market steps ahead of the economy in a fit of enthusiasm. This could be one of those times.

The Indian economy grew at an average rate of 6% a year for the first decade after the economic reforms of 1991. Yet, the Sensex kept going up and down in a tight range. This may not necessarily be how it will happen in the future. But investors must remember that there is a possibility of stagnant markets coexisting with booming economies for long periods of time.

The momentum of the past few weeks could push share prices to even higher levels in the months ahead. But all this looks too frothy to us. We can only repeat what legendary value investor Warren Buffett famously said: “You only find who is swimming naked when the tide goes out."

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