Are we near the end?

Emerging markets will get a jolt in the next six months, which will affect India.

As the markets, both globally and more specifically in India, keep rising, the inevitable doubts begin to resurface. Are we at a stage of euphoria creeping in? Aren’t the markets too hot, isn’t the flow of capital towards India unsustainable?

All these doubts inevitably come to the fore with markets having effectively doubled over the past 24 months, and given India’s historical propensity to disappoint just when every thing looks extremely rosy.

The genesis behind my thinking is driven by an article I read recently written by Jonathan Wilmot of CSFB. Mr Wilmot is the global strategist of CSFB and tracks a global risk appetite indicator on a weekly basis. This indicator tracks the level of complacency among investors and their ability and desire to take risk driven by interest rates and liquidity.

The article was fascinating as the risk appetite indicator tracked by Mr Wilmot moved into the euphoria zone just last week(indicating high complacency among global investors).

Prior to last week, this was only the 7th time since 1981 that the indicator had moved into this rarefied zone.

Interestingly, if one looks at the performance of global financial markets post a move into the euphoria zone, in six out of the past seven episodes global markets posted a new high for the cycle within three months, and in the other case the return was basically flattish.

But 6-12 months after the risk appetite indicator entered the euphoria zone, global equity markets suffered a major correction or bear market four times out of seven, traded sideways twice and rallied strongly only once.

The record for emerging markets is even worse. After the risk appetite indicator enters the euphoria zone, within six months of this in every single case emerging market equity returns have been negative.

Returns have varied from -1 per cent to -27 per cent with the average being -10 per cent. The greater vulnerability of emerging markets reflects their greater susceptibility to global monetary tightening and their inherently greater cyclicality and volatility.

In that sense the countdown has begun. If past financial market history is any guide, then we should brace ourselves for a significant emerging markets equity correction within six months.

Tie in the above with all the emerging signs of euphoria one can see in India. Over the past six months, more than 20 India dedicated hedge funds have been set up, more than the number that existed prior to these six months.

India dedicated country funds have raised over $1.5 billion from Japan (of all places) and all the NYSE listed India country funds have now gone to a premium. If one looks at the list of new 52-week highs(of stock prices), I would wager that most professional money managers have heard of less than 50 per cent of the companies on that list.

There have been three India investor conferences arranged by leading international brokerages over the past 45 days, each attracting more than 125 investors, of which atleast 30-40 per cent are first-time visitors to the country.

Imagine that, prior to 2003 if an India conference was able to attract even 40-50 investors it would be considered a great success.

Today over the past 45 days at least 450 investors have visited the country! Another indicatoris when one gets off an international flight, the line for Indian passport holders is dramatically shorter than the foreigners’ line, again very different from even 12-18 months ago.

Invariably hotel rooms are unavailable and the whole place has the look and feel of 1994(prior episode of India phobia).

The whole country seems to want to raise money, meet any company today, and besides its vision for 2010, everyone talks of fundraising and that too in multiples of hundred million dollars. Atleast 10 one billion dollar plus ADRs are lined up for launch over the coming 12 months.

There was a time when if the entire country could raise a billion dollars in international equity markets, it would be considered a great achievement. Today, single issues of a billion dollars attract little notice.

Even in terms of FII fund inflows, last year India attracted almost as much foreign flows as Korea and atleast 60 per cent of the number for Taiwan, despite both of these markets having much higher weightings than India in all emerging market indices (atleast 3-4 times).

For most international brokerages, India is now the second-highest profit pool in Asia and growing much more rapidly.

India has clearly been discovered, and is now enjoying its day in the sun, but are things going over the top?

If one forgets the anecdotal type of signs indicated above, one would argue that there is still a long way to go. The market has not entered a zone of irrational valuation, trading at 13-14 times 03/06 earnings.

Also, if one looks at other countries like Taiwan or Thailand which have gone through a similar period of investor discovery in the past, these moves tend to be multi-year and secular, with the market eventually going up 3-4 times from its pre move bottom.

Also, there is absolutely no sign of any weakening of the fundamentals from any quarter. Volume growth seems universally strong across all sectors and types of companies.

In addition, retail investor interest, while strong, is still nowhere near the levels of 1994 or 2000. We are yet to see hordes of people lining up in the hot sun to get an application form for the latest mutual fund launch, or IPOs of dubious quality trading at grey market premiums of 100-200 per cent.

If I were to hazard a guess I think we are very likely to get a significant correction within the next six months, but it will be driven by external factors. Emerging markets will get a jolt sometime in the next six months, and given the quantum and type of money present in India, this will invariably hit our markets as well.

Given the outperformance of global emerging markets over the past three years and the record low EMBI+(Emerging markets bond index) spread over treasuries, there is clearly a lot of money in the emerging markets world which does not need to be here.

At the first signs of trouble, it will bolt. This will invariably have an impact on India as well.

As for India-specific issues, politics comes top of mind. The situation in Bihar is currently being ignored but has clearly weakened the ruling coalition.

Thus, while the long-term picture still looks very good for all the reasons stated many times before, investors should be aware that a significant correction is probably lurking out there waiting for total complacency to set in.

Business Standard