Any deviation from fundamentals cannot sustain forever. Although liquidity may distort asset prices in the short run, the winner is inevitably the fundamentals in the long term.
I happened to have a chat with a stock broker friend of mine. He was euphoric about stock markets crossing 18,000 levels. I asked him wether he was worried; he replied, "The lesser you understand Indian markets, the more money you will make." He added that" you got to be a good jockey. If you jump off the horse in midst of the derby race, a few of your bones will be broken, but the horse will always move on (to 25,000)". This is the story of SENSEX or is it ‘X’ SENSE, where X stands for may be ‘NO’. As I was leaving, I heard him saying on the phone that the next 1,000 points would be a matter of next 5 trading days. Only one-way bets on stock markets!!!
I also called up the local jeweler and asked him, where he saw the Gold price going. In his opinion, it was Rs 20,000 per 10 gms, if dollar continued to depreciate. The real estate agent also jumps on and says, "Sell all your stocks and buy land on outskirts of Nagpur. Boeing will buy it from you at double the price after a year". I opined that prices have already doubled. He counters "So what??? Do Real estate prices ever come down? No supply & huge demand."
I quickly opened my old faithful Webster’s dictionary to look out for the correct interpretations of words like "Utopia" and "Asset Bubbles". I asked myself how all prices are going up together. When all asset classes move in the same direction, diversification is rendered redundant. And what about on the way down?
The Indian stock market index broke all time high records almost everyday over the last few weeks on route to crossing the 18,000 mark and coming perilously close to the 19,000 levels. Other asset classes such as crude oil, the U.S. stock markets, Indian Rupee, other emerging markets stocks (MSCI EM Index), commodities are also at record or multiple year highs.
Right from onions to pulses to real estate to stocks to commodities, everything is on a synchronized rising trend. And wages have also been sky rocketing.
Are Asset bubbles being created in India and the world?
What exactly has happened in India?
The roots are not in India, but thousands of miles away in the USA. Losing sleep over the housing and credit crisis, the Federal Reserve (the RBI of the USA) cut interest rates in mid September. Generally, lower interest rates are regarded as positive for the stock markets, since it lowers the cost of funds and enhances corporate investments & profitability. So when US house prices fall, go and buy Indian stocks. Read on to know why.
Lower interest rates and cheap money also encourages global investors to borrow & invest to generate higher returns. With lower cost of money, investors can afford to leverage, take more risk and invest into risky asset classes globally like stock markets in India. It is like a large bucket which, when filled with water beyond its capacity, will spill over the excess water into the neighboring smaller buckets, irrespective of the risk of drying up (losses) during the peak summer.
As Indian fundamentals continues to be attractive to global investors and as its markets integrate globally, more money comes in from the U.S. & other countries into Indian stocks and real estate, expecting higher returns. As the external liquidity rises, demand exceeds supply and asset prices move up rapidly. Real estate prices in India have risen significantly in the last 15 years.
Ever since the US Fed cut the rates (18th September), USD 6 Bn. (Around Rs 24,000 Crs.) have come into Indian stock markets, pushing the Sensex up by more than 3,100 pts (around 20%). From January this year, the Indian stock markets have got flows of more than USD 16 Bn. (around Rs 64,000crs). All this foreign money chases the index stocks, which move up rapidly. As can be noted from the table below, only the top 5 stocks have contributed to more than 56% of the Sensex rise, making it a little skewed and top heavy.
Is the prevailing liquidity and foreign cheap money undermining fundamentals & risks and in turn creating Asset Bubbles?
An Asset Price Bubble usually is a sharp rise in the prices of an asset or a range of assets; with the initial rise generating expectations of further rises and attracting new buyers, who generally are speculators interested in short term profits from trading in the asset, rather than its use or earning capacity (fundamental value).
In a typical asset bubble, the prices of the assets deviate from their underlying "fundamental or intrinsic values". An asset bubble is usually self fulfilling. Buying sends the prices up which causes other people to buy more. In a typical asset bubble scenario, experts often try to find a rationale for the overpriced markets (say structural changes or new economy) so as to not be against the crowd and everyone invests with the intent of finding a ‘greater fool’.
The world & India has a long history of asset bubbles bursting and an adverse impact on the financial markets & the economic system. India also has a precedence of scams & market dislocations erupting at the peak of the stock markets.
Any deviation from fundamentals cannot sustain forever. Although liquidity may distort asset prices in the short run, the winner is inevitably the fundamentals in the long term.
As globalization increases, the regulatory walls between countries crumble and capital flows move in & out of the countries with ease and with lot of speed, sometimes creating instability in financial markets & the economy.
A piece of advice to the retail investor in this euphoria:
| ä | It’s a myth that Indian markets are insulated from global developments. Our markets are exposed to the global vagaries. And FII flows are not necessarily driven only by fundamentals. |
| ä | Don’t get overwhelmed by the short term movements of the SENSEX, it’s only an index with 30 stocks. You may not own stocks in the index. There are very good chances that you might find more value beyond the Sensex stocks in a frothy market. |
| ä | Ask yourself a question. Have the underlying fundamentals changed? If PE ratio, a measure of valuation of stocks rises, earnings have to catch up or there will be risks of mismatched expectations. |
| ä | Focus on the long term investment horizon, underlying fundamentals of the stocks & the economy. Buy & Hold Strategy has outperformed the trading one in long term. |
| ä | Start early; invest regularly in a disciplined manner irrespective of the market levels. |
| ä | If you devote 1% of your day on investments, invest 1% of your net worth on your own. The rest can be managed by professional fund managers, viz mutual funds with disciplined research driven processes. |
| ä | Historical profits or higher cash positions should not drive buying decisions or increase your appetite for risk. |
| ä | Visible returns are accompanied sometimes by invisible risks. There are no free lunches; abnormal returns and higher risk are like Siamese twins. |
| ä | And remember; only profits are publicly discussed. |
| ä | Markets may not forever return 40-50% as it has been doing for sometime now. Expect rational returns. |
The Author is CEO & CIO, Quantum Asset Management Co.