Irrational exuberance

Print edition : January 30, 2004

The Bombay Stock Exchange. - SHASHI ASHIWAL

The defining feature of the current stock market boom, which is fuelled by FII inflows, is the absence of the retail investor, and this has raised doubts about the sustainability of the momentum.

THE stock market, already riding a wave of unprecedented inflows by Foreign Institutional Investors (FIIs), hit a record high soon after Union Finance Minister Jaswant Singh announced his mini Budget on January 8. The Bombay Stock Exchange's (BSE) Sensitive Index (Sensex) reached an all-time high of 6,250 on January 9, beating its previous best registered in February 2000 when the markets were under the sway of the Ketan Parekh phenomenon. The more sober index, the National Stock Exchange's Nifty, also breached the 2,000-mark for the first time on that day. The dizzying pace set by the markets in recent months, mainly on account of FII inflows, has broken several records. The Sensex, for instance, registered the fastest 3,000-point rise in its chequered history; it has doubled in the last eight months on the back of sustained buying.

However, the defining feature of the current boom is that unlike past episodes of extraordinary upsurges in the bourses, this time the retail investor has refused to enter the market. Why is this so? Part of the answer lies in the nature of the current boom, particularly the manner in which heavyweight FIIs have completely dominated the market. More importantly, the prolonged neglect of the interests of long-term (read small) investors, particularly because of the lack of regulatory oversight, has prevented the market from developing an adequate depth. This lack of depth raises fundamental questions about the sustainability of the momentum in the markets.

FII investment, after having peaked in October 2003 - when the net purchases of Indian stocks by FIIs reached Rs.6,863 crores - surged again in December when net investments amounted to almost Rs.5,411 crores. Since September 2003, when FII investment started to spiral, total investments by FIIs in India have amounted to more than Rs.20,000 crores. It is obvious that the current boom is mainly because of the spiralling investments made by the FIIs. The point is whether the upsurge in stock prices is sustainable.

Market analysts say that the FIIs have turned to India for a variety of reasons. There are those who believe, for instance, that the boom in FII investments started initially because FIIs saw arbitrage opportunities in the interest rate differentials between markets in India and overseas.

L.C. Gupta, director, Society for Capital Market Research and Development, says: "This boom is clearly a result of FII inflows. It coincides in time with FII inflows. FII inflows initially started because they wanted to take advantage of the interest rate differentials." FIIs are believed to be betting not only on Indian stocks and interest rates but also on the rupee, particularly vis-a-vis the U.S. dollar (Frontline, December 5, 2003).

Another viewpoint explains the sustained FII interest in terms of the policy regime governing Foreign Direct Investment in crucial segments of Indian industry. Market-watchers have pointed out that the FIIs have not been buying stocks across the board. Instead, their interest has focussed on several key segments. Bank and telecom stocks, for instance, have been under sustained buying pressure from FIIs in the past several months. Oil sector stocks too attracted the interest of FIIs.

The sustained buying by FIIs is explained in terms of their belief that the policy regime, particularly those relating to sectoral caps on FDI, is amenable to external pressures. This reasoning, which is backed by way of tangible examples of the raising of sectoral caps in the banking and telecommunication sectors, points to the fact that by purchasing stocks of specifically targeted companies in these sectors, FIIs are hoping to make gains that would be far above normal returns that ordinary investors would get.

It is argued that by purchasing shares of companies which may possibly come under foreign control at a later stage, FIIs may be able to sell shares at a premium at a later date to foreign entities which may take a controlling or strategic stake in Indian companies in sectors such as banking and telecom. What this means is that FIIs are betting safely because they are aware that the policy regime is elastic in terms of its ability to adjust to the needs of foreign investors.

*Up to January 6.

OBSERVERS of the Indian capital market have pointed out that booming markets are not a good sign because they deter sensible long-term investors. L.C. Gupta points out that investors normally expect companies to plough back a portion of their profits as payouts to investors, reflected in the earnings per share (EPS). Thus, it would be normal for a well-managed company to maintain a rising trend of profitability over a period of time.

Gupta says: "If prices rise in step with corporate earnings, it would not be difficult to understand. My point is that this kind of boom does not seem to reflect this logic. Although there has been talk of good results of companies in recent weeks, the point is that a mere one year's results cannot justify this kind of euphoria."

Market analysts also believe that the prices of shares reflect their future cash flows in terms of dividends and other payouts to those holding them. It is obvious that a single year's corporate results cannot provide an accurate measure of long-term corporate profitability. Do the share prices, at their current levels, reflect the increase in profitability over a reasonably long period? Based on his research on long-term corporate performance, Gupta believes that "no company can show extremely high earnings per share over a long period of time".

Studies of investor behaviour, particularly in the new area of behavioural finance, have offered insights into the way investors move in and out of the markets. Gupta believes that the current boom is something that "usually happens" in the share market. Market operators, acting in concert, often try to entice ordinary investors to buy certain stocks. When people see that a certain share's price is rising, they are attracted to it. They may not know about the fundamentals of the sector, they only know that the share price of the target company is rising.

Gupta observes that investors are prone to be afflicted by the "herd mentality". "If a lot of people believe that prices will rise, prices will actually rise."

Analysts do not expect the retail investor to enter the market. Pointing to several studies, Gupta argues that retail investors have bided their time as stock prices remained stagnant over a prolonged period of time. He points out that the Sensex has remained in the 2,800-3,200 range for several years and the price-earnings ratios of shares were also stagnant. Drawing from the results of a survey of more than 3,000 investors, which was conducted by the Society of Capital Market Research and Development for the Industrial Development Bank of India (IDBI), Gupta says most investors said that they wished to liquidate their stocks rather than enter the market to buy shares. He said: "People, it appeared, wanted to sell, but only at a price that was attractive. My understanding is that since 1997 ordinary investors have been trying to get out of the market."

Although the retail investor figures in the regulator's list of priorities every time the market is rocked by a scandal, most observers do not believe that the market has accommodated his/her interests. Gupta told Frontline that the government "does not seem to be particularly interested in encouraging the retail investor". There are those who believe that the retail investor need not invest directly, and that he/she ought to invest through the medium of mutual funds. Gupta argues that "these are not correct notions". The regulators, he points out, should be "controlling fraudulent practices" in the markets. Although the investor may make wrong judgments at times, he/she must be protected against frauds. Gupta says the stock market regulatory system has not been able to "control frauds and manipulations". Consequently, investors have suffered.

Gupta says: "If markets are regulated effectively, small investors with a portfolio of 8-10 shares ought to get a reasonable rate of return on investment if companies are reasonably well managed. The point is that we have not even been able to put in place a system of corporate governance in India. A code has been framed, but there is resistance from the business houses. I think a healthy market requires retail investors. A boom means an extraordinary rise in share prices. Why should anybody buy at those levels? Shares, like just about anything else, ought not be bought when the prices are high. That is not a good thing for markets.

Data on the number of investors show that the investor base has been shrinking in India. For instance, surveys conducted by the Securities and Exchange Board of India (SEBI), in association with the National Council for Applied Economic Research (NCAER), show that the number of investors in India declined from 2.3 crores in 1997-98 to 1.9 crores in 2000-01.

Moreover, data on the number of dematerialised accounts of shareholders indicate that a significantly high proportion of shareholders have no intention to trade regularly in the stock market. Although SEBI has mandated that trading in the market requires holders of stocks to hold them in dematerialised (paperless) form in specified demat accounts maintained by specified agencies, a substantial proportion of investors continue to hold them in the physical form. Gupta points to the fact that investors incur substantial costs not only because they have to make payments for their demat accounts but also because they incur costs on each transaction they make in the market. Consequently, only 44 lakh - of the two crore shareholders in India - maintain a demat account.

It is obvious that following successive bouts of excesses in the market, the participants in the current boom are confined to a very thin segment. Apart from the FIIs, brokers have also taken positions in the market, apart from executing trades for their own clients. There are also small companies that are active, acting as fronts for other market operators. Immensely wealthy individuals, covered by the term high-net-worth individuals, are also part of the herd moving the market into a frenzy.

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