BULL's PEAK?

(Recently published in Moneylife magazine)


Some people seem to think there's no trouble just because it hasn't happened yet. If you jump out the window at the 42nd floor and you're still doing fine as you pass the 27th floor, that doesn't mean you don't have a serious problem. I would want to address the problem right now." - Charlie Munger

Our markets continue to be on a tear. The flood of FII money, with more than thirty billion dollars having come in the last twenty months, has been the main driver. Domestic flows have been small and on its own could not have provided the legs for this rally.
Foreigners across the globe want to be invested in Indian markets, because our bumbling efforts to get any kind of decent share in global trade have suddenly become a virtue! For foreign investors the routes are limited to using either the registered FII route or the ETF route. The ADR stock of Indian companies is lower than that of Chinese companies, so the money flow is severe. Also, China does not allow FII moneys like we do.
As the indices keep shooting up, the first fear is of 2008 happening all over again. I was talking to a friend and he said that these are the ‘bull’ factors for the markets:
i) Our economy will grow at 8% plus, irrespective of global conditions. (this may be true in the short term alone. In the long term, if the global economy does not recover, Indian growth will slow down as retaliatory/protectionary measures set in);
ii) The forward earnings multiples today are lower than what they were in 2008. One estimate says that the BSE Sensex, at 19500 is trading just at 15 times 2011-12 earnings. I think the earnings growth keeps getting revised upwards by brokers as the markets keep going higher. The advance tax numbers to September 2010 show only a 13% rise in advance tax numbers for the top 100 companies. This means that the earnings growth is under 15% or else the numbers are getting fudged;
iii) The long terms story is that as Indian economy keeps growing, over the next ten years, in each industry sector, we will have two to four giant players (for inst RIL, BHEL, SBI, HLL) who will be global size and if you look at their profile ten years from today, you are getting them cheap today. Foreigners have realised this and are piling on to the front line stocks. This is a logical argument, but it is like buying 2015 earnings now. What if in 2015 the earnings have not caught up? Upside from here seems to be absent;
iv) The US dollar is set to weaken and hence the foreign investors would also like to invest in Indian equities which not only have a good story, but strengthening of the Indian rupee will also contribute to a higher return on investment. Looks logical, but with India running a trade deficit in excess of US$ 10 billion per month and inflation upwards of 8%, the rupee has no legs. It is only the capricious capital flows that are propping up the rupee. Also, the regulators have a defeatist approach to Indian exports and will not let the rupee strengthen;
v) The general argument is that whilst valuations are a bit aggressive, this time the downside seems small because the fundamentals are strong. This argument does not hold water. Fundamentals are markets do not go hand in hand for any length of time. Markets remain overvalued for long time and remain undervalued only for short periods. This is simply because there is too much money in the world which due to the global meltdown, gets no return and has turned to markets like India in their greed for higher return. Our markets can tank below the 2008 levels if the FII flows were to reverse. When I tell this, I am a loner in the room. No one wishes to believe or accept that if the FII’s pull out, say twenty billion or so dollars over a fortnight, we will reach that kind of a level. Of course, what will prompt them to do that seems to hold the key. Let me say, I am less in disagreement with this than most other bull arguments;
vi) Real estate sector is yet to recover. If you look at the index, it is just around five stocks (SBI, HDFC, L&T, ITC, HDFC Bank) that have contributed to the rise. Hence, the markets have a long way to go, as other stocks also participate in this bull run. I find this argument full of holes. After a long time, I see that the sensex does not have a single stock with one digit P/E multiple. Even cyclical stocks like Hindalco trade at near twenty multiples. In fact, it is difficult to find any value buy in this market. You have to bet on high growth. Many will falter, some will achieve. It is a tightrope of expectations, where one stumble can happen anytime. Talking about real estate, the stocks are trading at anywhere between thirty to fifty times earnings. Finance sector is now trading at over four times book value!

Without being alarmist, I would definitely advise people to take a pause and then proceed. Interest rates are still high and may go higher, even though the policy makers seem to indicate that they have run out of ammunition to halt inflation. They have now taken recourse to changing the method for calculating inflation. Wonder when they will realise that it is not money supply which is the cause for this inflation but the simple fact that there is a supply shortfall. I was at a friend’s office that has an agency arrangement for motor vehicle spares. Most spares have a waiting period! Demand has gone up due to reckless credit expansion and the service industry job creation that has thrown easy money at so many people with virtually no skills. Every company I talk to is scared about the quality of labour they get and the high attrition rates. These are definite pointers to inflation being a real scourge.
The other factor to look out for is the slowing down in the pace of deposit growth at banks. This will lead to an increase in deposit rates, as banks use it as a tool to attract a larger market share of deposits. Our banks still worry about deposits size rather than profitability.
State and central governments are throwing freebies after freebies at the populace as many states enter in to an election phase from next year. The combined fiscal deficit of state and centre continues in double digits. A onetime bonanza from the 3G auction is being wrongly accounted to show a lower deficit. It is like selling family wealth to meet the food bill.
A record IPO flow is going the hit the markets in the balance of this year. I have not seen so much aggressive pricing even in 2007-08. Add to this the fancy pricing for exotically labelled sectors like microfinance. This is a right brew that usually points to a peaking in the bull story. Promoters have stopped issuing shares to themselves at these prices, rather choosing to dilute. They have all tanked up their personal treasuries with warrants issued to themselves during the fall in 2008. Now they are primed to dump it on the investors.
I also see a big range of upward revision in earnings forecasts, which seem dubious and smells more like a ‘sell’ side attempt to justify higher prices. When the markets were near 10K, I saw at least three in ten were ‘sell’ recommendations from brokers and research analysts. At 20K, the ‘sell’ reports are missing altogether from the brokers. This is perhaps a good indicator of where the markets are headed.
Take care. The markets are slippery.

R. Balakrishnan
(balakrishnanr@gmail.com)
September, 18th, 2010