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September 20, 2007

Indian Economy|Capital Markets

Share Market Risk

By Nitin Desai


Two months ago when global stock markets were booming this column asked whether the party would continue and suggested that policy makers should prepare for less favourable times.  A few days after that, the current phase of global financial turmoil started.  For the past two months stock markets the world over have been on a trampoline, moving up and down wildly from day to day and even within each day.  Is the next adventure for market players a bungee jump?


The behaviour of stock markets in the short term is affected by sudden changes in the availability of liquid funds in the hands of the big market players, which is what has happened now with the sub-prime crisis and the changed economics of the yen carry trade with yen appreciation.  The fall-out in India was triggered by the movements of FII funds as they flew to what they think is ‘quality’. 


The other short-term factor is what the trade press politely calls ‘investor sentiment’ but which is better described as ‘irrational panic’.  The main victims of this disease are seldom retail investors and are mostly the analysts in hedge funds and elsewhere.  Their blogs are worth tracking for the way in which opinions based on flimsy evidence spread like an epidemic.  (Pessimistic forecasts are safe because, if the worst does not happen, people are too relieved to blame you for being a ninny!)   


For instance in the early part of this year some of these blogs spoke about a 50% drop in profits in the companies in the Sensex.  But the available corporate results do not suggest that anything like that is happening.  According to the RBI’s quick tabulation of corporate results, given in a recent presentation by Deputy Governor Dr. Rakesh Mohan, corporate PAT grew by 32.6 % in the first quarter of 2007-08 against the average of 38.4% in the previous two years.  However it is possible that profit performances reported later in this year will be worse because of rupee appreciation as foreign exchange earnings account for nearly a quarter of corporate sales now. 


All the evidence indicates that in the long run stock prices reflect underlying fundamentals, of which the most important is corporate profitability.  In India the growth in the stock market indices, by and large track the growth in earnings in the underlying companies if we look at a comparision over years rather than days or weeks.  The current boom in the Sensex started in 2003 and between March 2003 and March 2007 the Sensex has risen by 429% while the growth in corporate earnings over this four-year period has been 432% according to RBI data. This suggests that market trends are in line with fundamentals.


Market capitalization is not, repeat not, one of the fundamentals that the Finance Ministry, RBI or even SEBI should worry about.  Small investor protection has to be covered by the rules set by SEBI and these do not include any insurance against market fluctuations.  Caveat  emptor has to apply to all, large or small, who voluntarily take on the risks of equity investment.  Newspaper headlines about how many thousand crores have been added or deducted from investor wealth by some large share price movement are of little importance.  They do not measure any significant change in the real economy where the stock of real capital and the rate of real investment is what matters.


Policy makers should not run a welfare state for rentiers and go about rescuing those who have misjudged market trends. There are however some substantial grounds for trying to influence stock markets with strategically timed policy announcements or emollient talk from various financial dignitaries.


First, stock market behaviour in the form of high volatility and irrational exuberance or panic can distort savings and investment motivations. The wild gyrations of the Indian market in the first half of the nineties reduced  the appetite for equity among savers and thus affected the rate of corporate investment. Since 2002-03 we seem to have come out of that and policy makers must be ready with “psy-war” tactics to counter any reversal of the very positive environment for corporate investment that we have had for close to five years now.


Second, when the market jumps up and down wildly, as in the past two months, the big institutional players seem to act as a herd within each class.  So when FIIs decide to buy or sell a whole lot of them do so more or less at the same time.  Perhaps this is because they are all being advised by analysts who think alike, a factor reinforced by the huge exchange of information and opinion between them. This may amplify volatility if there are only a few classes of big players.  Hence, in order to increase the number of big players, other potential players like pension and provident funds, insurance companies and other financial companies must be allowed greater latitude in entering the market.


Third, our financial panjandrums must move from being worried to being scared when irrational exuberance affects both the stock market and the property market and the two booms get linked. These two markets are the ones where valuations can move well outside the range of the underlying fundamentals.  The sub-prime mortgage crisis is a manifestation of what happens when the waves in these two casinos are in phase and reinforce one another.  In India, with realty companies going public, non-realty companies going in for SEZs in a big way and older companies cashing the value of their land holdings a fall in the property market will affect the stock market more directly than in the past.


Global markets will remain on edge for the next few months because of what may happen in the US exchanges. What will the herd of nervous punters in New York, London and Hong Kong do?  Will they see India and China, where the growth fundamentals are strong, as safer options for equity investors? Is a  new large conduit opening in the private equity flows to these markets? Or will a general flight from equity affect the FII flows to these markets also? The answers are uncertain; but on balance a bungee jump looks unlikely.  Hence in setting interest rate, exchange rate and capital market policies the authorities must focus on fundamentals and calm the nervousness of market players with bedside talk rather than any drastic medication.


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