A boom before a bust?

The boom in the stock markets, led by foreign investors, does not appear sustainable.

THE markets are once again on song. Riding on the back of a deluge of investments by Foreign Institutional Investors (FII), the Bombay Stock Exchange's (BSE) Sensitive Index (Sensex), an index consisting of the 30 bluest of blue chips, has shot up astonishingly in the last few weeks. The "feel good factor" is so strong that euphoric stockbrokers, investment analysts, fund managers and the media predicted that the Sensex is likely to hit 8,000, after it breached the "psychological barrier" of 5,000 after the recent announcement of the Reserve Bank of India's credit policy for the next six months. How long will this rally last? Or, to phrase it differently, when will the markets crash? Although such a question may appear to be impolite at a time when the party is on, wary investors are already asking them.

In late April, the Sensex stood at about 3,000. This means that the index has registered an astonishing increase of 66 per cent in a little over six months. The index registered its fastest 2,000-point climb in a decade, on October 18 in 123 days. (The record for the fastest 2,000-point climb in the Sensex was just 31 days, between February and April 1992, when Harshad Mehta's touch turned every stock into gold till the scam halted the biggest bull run in the country's markets). The index is at its highest since late 2000. The question is whether this rally is sustainable.

There are those who believe that the current rally, although led by the FIIs, is likely to be sustained. They say that this a broad-based rally, and unlike other previous episodes of upswings in the Indian bourses. The good monsoon, resulting in a 20 per cent higher kharif crop, is one reason for the optimism. The flow of good tidings on corporate performance in the first half of the current year is explained as another. The better performance on the industrial front is said to be another factor accounting for generally upbeat assessment of the Indian economy. The optimists suggest that these happy tidings lay the basis for the "feel good" factor that is lifting the markets to new heights.

However, sceptics are not convinced. The kharif performance, they say, needs to be placed in the context of the sharp fall last year, when agricultural output fell sharply because of the severe drought. Moreover, industrial output has only improved marginally in April-September, when compared to last year. Instead, the fact that credit offtake has not increased significantly, despite flat interest rates, points to a sluggish economy lacking in confidence. The growth rate of exports in the current year have halved compared to last year. Moreover, the burgeoning foreign exchange reserves, which has led to an appreciation of the rupee against the dollar, threatens to hurt exporters even more. Why are the markets booming when happenings in the real economy do not warrant reposing confidence in it to the extent that the markets appear to be? The answer to this would appear to lie in the particularly striking elements of the current boom.

THE most important characteristic of the ongoing boom is that FIIs are driving it. Between April and early November 2003, net investments by FIIs in Indian markets crossed the $5-billion mark. To place these figures in context, the last peak in a full financial year was in 1996-97, when FIIs invested funds amounting to $2.4 billion in Indian markets.

It is well known in stock market circles that FIIs are extremely choosy about their pickings. More enlightened participants in the market have for long pointed the lack of depth of the Indian market. What that means is that, at any given time, too many investors are chasing too few good quality stocks. The entry of FIIs, with their huge financial clout, has queered the pitch even further. A report earlier this year indicated that more than half of the FIIs investment in calendar year 2002 was in merely five scrips figuring in the Sensex. According to recent reports FIIs hold roughly 14 per cent of the entire market capitalisation of shares traded in all Indian stock exchanges in India (market capitalisation, a notional concept, is the combined value of all shares that are listed in the exchanges). Although this by itself indicates a high level of concentration of stocks in the hands of a few entities, the fact that FIIs hold a substantial proportion of stocks in "free float" indicates an even greater degree of concentration in holdings of good quality stocks. Stocks in "free float" are those not held by company promoters, institutional investors and the government. In other words, stocks in "free float" are those that are ordinarily available to investors. Recent reports indicate that FIIs command 45 per cent of the "free float" market capitalisation in the BSE. It is also estimated that FIIs own 40 per cent of the free float in the top 100 shares in the BSE. Indeed, there is apprehension that the hectic buying by FIIs has drained the pool of "free float" available for purchase in the market.

Prithvi Haldea, managing director, Prime Database, believes that this rally is "substantially dependent" on FIIs. In fact he believes that the market needs continued support from them. "Any mass selling by FIIs will definitely hurt the market because the Indian counter parties just do not exist." Haldea says that although there may not be "fundamental reasons" for FIIs to sell, there could be a profit-taking pressures, particularly at the end of the year when there is normally a tendency for them to book profits. "There could possibly be large sales coming up, which could hurt the market," Haldea surmises.

Haldea observes that FIIs buy only a "limited range of stocks", those in the Sensex, for instance. "The rally," he says, is "`broad-based' only in a limited sense." He adds: "As blue chips become pricey, people start chasing other stocks. It also increases risk because the later entrants start chasing price and not value. When investors start doing this, they are inviting trouble. For example, initially people may be chasing the Tisco scrip, but as the market gets heated up, investors start buying shares of other steel companies because they cannot afford Tisco shares."

Even optimists point out that the retail investor is yet to participate in the boom. Haldea argues that a sustained rally can be possible only when the number of investors increases. Moreover, there are no longer any strong domestic institutions active in the market. Earlier, Unit Trust of India (UTI) or the mutual funds owned by public financial institutions played an active role in the market. Their weak presence in the market brought into doubt the sustainability of the boom.

Another facet of the current boom is the upsurge in the derivatives section of the stock markets. Haldea believes that FIIs are exploiting "arbitrage opportunities" between the cash and derivates markets, which he says has driven the derivatives market even further. In fact, there have been some reports since mid-October that FIIs are selling future contracts even as they bought shares in the spot market. This has raised speculation that FIIs are about to sell equities and book profits.

S.L. Shetty, Director, Economic and Political Weekly Research Foundation, is critical of the move to open Indian markets for derivatives trading. He says that Indian policy-makers have opened derivatives trading although the country's infrastructure, its institutional structures or its stage of development do not allow this. He points out that even in the United States, derivatives in individual scrips were not permitted until very recently. Shetty says: "Trading in derivatives is nothing but pure speculation. It is increasingly overpowering the regular transactions in the markets. They represent another element in the scheme to develop a capital market-centric macroeconomic policy."

MOST serious observers of the stock market have stopped regarding the market's performance as a reflection of the real economy. He says that it would be a mistake to dismiss the rally as not having any basis on economic fundamentals. Haldea says: "I can list ten reasons why the market is booming. I can then explain why the boom is happening and relate them to the fundamentals. But if the markets were to fall tomorrow, I can list ten other reasons as to why this happened. That too would appear very logical. Basically, the market needs stories to move up or down."

Haldea warns that if the ordinary investor "gets hurt again, the markets are likely to remain in a collapsed state for at least two or three years". He is also concerned about the possibility of a revival of the Initial Public Offers (IPO) market. He says: "We hope to see an IPO rally, if not a boom." IPOs, he says, are essential for providing capital for the economy. "For IPOs to happen the market needs a sustained and stable rally for at least 12 months in the secondary market. The focus should be on restricting speculation and preventing any scams that may be in the making".

Haldea says that in any given market, and more so in the case of the Indian market, which is still developing, "people start believing the stories of the dream-makers". He says: "Currently, stockbrokers, analysts and fund managers are talking about the Sensex reaching 8,000. I think it is illogical to predict that the Sensex will reach 8,000. Those with a vested interest are building such hopes and dreams among ordinary investors. They are saying that Indian stocks are still underestimated. My point is that three months ago, when the fundamentals remained the same as they are now, I would have thought all these stocks were overpriced."

There is widespread concern that the markets are heavily dependent on FIIs. Haldea points to the widespread fear that FIIs normally work in herds, selling or buying stocks in tandem. He says: "After having allowed them, we have to now live with the evil (FIIs)." He suggests the total exposure of FIIs in floating stocks of companies needs to be regulated. The huge funds at their command enable them to hold 60-80 per cent of the floating stocks of companies. Haldea says that regulatory intervention "will reduce the markets' dependence on FIIs". "I also think that there should be greater transparency of ownership of FIIs. Who owns the FIIs that are dealing in the Indian markets? We often do not know the ultimate owners of these entities. In several cases, investment that has reached the prescribed caps set on Foreign Direct Investment (FDI), is now being done through the FIIs. This is happening in the case of bank stocks."

Shetty relates the absence of good quality stocks in the market to the growing pressures on Indian manufacturing. He says: "Good scrips are very scarce. From the point of view of potential investors, the corporate sector is not broad-based. This is because 12 years of reforms has killed Indian manufacturing and prevented a broad-based entrepreneurship.

Shetty regards the stock market as a "sensitive financial institution". He is against allowing bulk funds to gain control of such an institution. Bulk funds have the ability to turn funds around at their own whims. They come in when the rates of return are lower abroad, and go out in order to book profits in India. Shetty says that, "Indian policy-makers have given these funds a large and growing economy on a platter". Even a relatively more advanced economy like South Korea did not allow short-term foreign funds because they tend to destabilise markets. This policy was based on the understanding that bulk funds, which were only interested in large secondary operations and without any relationship to industrial projects, would result in large fluctuations in the stock market.

It would appear that the low interest rate regime governing most savings instruments would nudge ordinary investors in the direction of the stock market. But, given the risks that they have time and again felt in the last decade, the strategy to remain tied to a low interest instrument would appear to be a perfectly rational decision based on sound experience. Shetty observes that small and ordinary investors, when faced with violent fluctuations in the market, react with surprise. Their immediate impulse is self-protective and, therefore, they stay away. Moreover, in a situation in which share prices have lost their moorings in the real economy, they are impossible to predict. Shetty attributes "the destruction of the primary market" to the way the FIIs have played in the Indian markets. Moreover, the slide in public and private investment and the process of economic restructuring have contributed to withdrawal of the common investor from the share market. But, he says, that one of the major factors for this withdrawal has been the destabilising influence of money coming from abroad.

Shetty argues that the "market-centric approach" arises out of the mindset that does not give importance to governance. Rather, image-building is seen as more important. A sound investment policy that encourages and promotes the corporate sector is what India needs, says Shetty. "The capital market-centric approach is like the tail wagging the dog."