Sensex and re-coupling

The carnage of the past two days has generated intense debate on what the Government should do to pacify the markets. There have been voices of concern from across the spectrum. But apart from the fact that any such precipitous decline calls for expressing concern, there appears very little we can do and should do about the events unfollding in the financial markets. Unlike in the US, the volatility in the financial markets does not call for much concern for the following reasons

1. Our markets were in any case over-valued, both in pure financial market terms and in relation to the real economy. At PE multiples of 22-27, we have the highest PE and PB values in the world, apart from China. PE multiples rose from 16 to 27 in the two year period of 2006 and 2007. The market capitalization to the nominal GDP ratio rose to 173% at the end of December 2007, a rise of 73% in the year. This is to be seen in light of the historical average M-Cap/GDP ratio of 37.5%, and an average ratio of just 47% for the entire 2004-07 bull run period. A correction was therefore long coming.

2. The economic fundamentals are strong - low inflation, strong currency, growing trade, rising savings and investment, robust demand, excellent corporate earnings, buoyant tax revenues etc. This is the ideal occasion for any equity market correction, in so far as we are better positioned to absorb the shocks.

3. Only 7% Indians own shares, directly or indirectly, compared to more than half all Americans. There is no substantial "wealth effect" due to shares that would now drag consumption down in India. The real economy is much less coupled to the financial markets than elsewhere. So less danger of a spill over to the real economy.

4. Unlike the US, we do not have any solvency problem with our financial sector. Banks have all posted record profits and robust top line growths. At worst, we could experience some form of liquidity problems.

5. A substantial contribution to the exit stampede has been due to margin pressures leading to brokers squaring off their positions. It has for long been a concern that the market had been over leveraged. This is reflected in the massive build up in the futures and options market, with repeated roll overs of leveraged long positions in expectation of windfall gains as the market keeps moving up. The average open interest position was Rs 1,31,000 Cr on 18 January 2008, as compared to Rs 92,538 Cr in October 2007.

6. The recent massive over-subscription for the Reliance Power IPO by retail investors, is an indicator of the huge liquidity available in the market. However, a more immediate contributor to the collapse could be the recent round of IPOs and NFOs, especially of the Reliance Power IPO, and the huge repsonses generated, which may have drained out liquidity from the markets. In fact the Reliance Power IPO drew about $190 bn worth bids for $2.9 bn worth shares, thereby draininng liquidity, forcing margin calls and thereby liqiudation of long positions.

7. One of the major contributors to the bull run over the last year has been the huge FII interest in emerging markets. Assets in emerging market funds doubled to $800 bn in 2007. FIIs pured $16.7 bn into India in 2007. The bullish outook of FIIs fuelled a similar, even more gung-ho sentiment among local institutions and investors.

8. There is very little we can do to control trends and forces, which have global dimensions. It is undeniable that the FIIs and events outside our country (like cuts in US interest rates and the arrival of emerging markets as attractive alternatives to the US and other developed markets) played a critical role in driving up Indian shares, and it is therefore understandable that they react to developments that have implications on their market positions, especially in the US market. Given the exceptional circumstances facing the global financial markets, and the large losses suffered by some of the biggest Wall Street Banks, it was only to be expected that the Indian markets get affected. We cannot enjoy the upside of the global financial markets, while not suffering the downside!

9. Such asset bubbles are not uncommon with economies growing at the pace at which India is. They rarely cause any lasting damage to the growth prospects.

Foremost, we should keep in mind the fact that the reasons for the declines in US and elsewhere are entirely different from that here. US is, to put it mildly, facing a dual crisis of a financial meltdown and an economic recession. The financial crisis may be accelerating the manifestation of fundamental demand side problems with the economy. On the contrary, the declines experienced in India are primarily a consequence of the deeply coupled nature of global financial markets. In other words, the reasons for the decline in Sensex are mainly exogenous.

We merrily shared in the "irrational exuberance" of the sub-prime lending and emerging market craze of global investors, and now as is the case with all such exuberances, reality has dawned. For the immediate, the declines present an excellent opportunity for investors to pick up shares on the cheap. In the long run, the events of the last two days will only be a blip in the horizon, an inevitable consequence of being active participants in the roller-coaster ride of the global financial markets! In fact, the unprecedented 75 basis points cut in the Federal Funds rate to 3.5%, could be just about enough to stem the tide and even reverse the bear run.

Update
It is business as usual at the markets, as the US rate cuts have provided the boost. With further rate cuts expected, both at home and the US, I have a feeling the events of past few days will soon be forgotten, only to be shaken up by another steep correction sometime later.