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The Indian Stock Market Continued Boom or Impending Bust?
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by Evalueserve 48 India

“But how do we know when irrational exuberance has unduly escalated asset values, which then becomes subject to unexpected and prolonged contractions as they have in Japan over the past decade?“ – Alan Greenspan (Dec 1996)

“Irrational exuberance” is now a well-known phrase that was once used by the former United States Federal Reserve Board Chairman, Alan Greenspan, in a speech he gave at the American Enterprise Institute in December 1996 - a period during which the US stock market witnessed a boom. Interestingly, the US stock market, particularly the NASDAQ, continued booming after his speech for more than three years before it crashed heavily!

During the last 42 months, the Indian stock market, as represented by two major indices - Sensex (Sensitive Index) and BSE-100, has grown by approximately 290%. This corresponds to a cumulative annual growth rate of 36%. The Indian market is somewhat unique in the sense that the country’s economy has been growing at a rate of over 8–9% per year in real terms and at 14–15% in nominal terms. Many investors believe the rising valuations of stocks in India are justified because “this time, it is different”. Of course, everyone has heard this phrase before, but we wonder whether things are really different this time around, or whether investors are setting themselves up for another major correction in the prices of various assets. In our opinion, since India has a large budget deficit (a large part of which supports unproductive subsidies and salaries of government employees) and a large current account deficit, Indian markets may be quite vulnerable to a sudden flight of capital and a potential downturn in the market. On one hand, there is enormous liquidity in the global market and this liquidity is likely to continue growing (at least in the near future). On the other hand, the enormous inflow of foreign currency in the Indian stock market, particularly by foreign institutional investors (FIIs), seems to be a cause for worry as this money is also susceptible to a quick flight out of India. Moreover, this inflow has appreciated the Indian Rupee substantially and has begun to hurt both Indian exports and the domestic industry.

Given this backdrop, in this article, we investigate whether the recent, sharp growth of the Indian stock market is justifiable or whether it is also a case of “irrational exuberance.” Indeed, if it is the latter, then the impact of its downfall will be felt not only in India, but also worldwide. We also discuss several scenarios and highlight some silver linings that may keep the Indian economy in a good growth mode.

Executive Summary

During 2005, India’s economy grew by 9% and reached US$ 800 billion, and during 2006, it grew by another 9.2% to reach US$ 910 billion (in nominal terms). At the same time, during the last 16 years, i.e., 1991–2006, annual inflation - as measured by the average Wholesale Price Index (WPI) - has been approximately 6.7%, and given the savings rate and liquidity in the system, our analysis shows that the annual inflation in the country will likely to hover around 5% during the next 14 years (i.e., until 2020). So, assuming a constant exchange rate where one US Dollar equals 40 Indian Rupees, India’s economy is likely to be US$ 1,030 billion in 2007, US$ 1,490 billion in 2010, and around US$ 5,040 billion in 2020 (all in nominal terms). This implies that including inflation, there will be approximately a five-fold increase in India’s economy between 2007 and 2020.

Given such a strong growth rate of the Indian economy and the enormous liquidity worldwide, during the last 42 months, the Indian stock market, which is epitomized by two indices - Sensex and BSE-100, has grown by an average of 290%, thereby achieving a cumulative annual growth rate of 36%. However, there is substantial cause for concern for the Indian stock market in particular and the Indian economy in general. Given below are some reasons for this concern:

  • The Sensex or “Sensitive Index” (with a base of 100 in 1979 and comprising 30 companies listed on BSE) and BSE-100 (with a base of 100 in 1984 and comprising 100 stocks listed at five major stock exchanges in Mumbai, Calcutta, Delhi, Ahmedabad, and Chennai) epitomize the Indian stock market. From a Price/Earnings perspective, the Sensex and BSE-100 stock market indices are close to their 1999–2000 dot-com boom era peaks of 29 and 25. Furthermore, Sensex has grown from its lowest point of 2,600 on September 25, 2001, to 20,030 on December 15, 2007. Similarly, BSE-100 has grown from its lowest point of 1,216 on September 21, 2001, to 10,965 on December 15, 2007.
  • An excessive supply of foreign exchange has also appreciated the Indian Rupee substantially. Although India’s central bank, the Reserve Bank of India, has bought foreign exchange worth US$ 52 billion in order to keep the appreciation of Indian Rupee to manageable levels. The Indian Rupee has already appreciated by 15.4% during the last 12 months, from 45.34 on December 15, 2006, to 39.29 on December 15, 2007. This is clearly hurting Indian exporters, who are also beginning to lose out to Chinese exporters since the Chinese currency has appreciated only by 5.2% during the period. Since the appreciation of the Indian Rupee is beginning to hurt the profit margins of Indian exporters, it is also beginning to depress their market valuations - some of them may not be able to survive. Moreover, since some imported goods from China have become substantially cheaper, a portion of the Indian domestic industry is also beginning to be hurt significantly.
  • Most of the money in the stock market - as much as US$ 49 billion during the last 51 months - seems to have been pumped into the Indian economy by foreign institutional investors (FIIs), and this infusion seems to be based more on “market sentiment” than on the inherent growth of the economy or the short-term appreciation of the Indian Rupee or the companies that constitute Sensex or BSE-100. Our models, back-testing, and related analysis show that an outflow from India of even one-fourth of this money (i.e., approximately US$ 12 billion) may depress the stock market by 30%, which would imply that Sensex would fall to approximately 14,000 (which is where the Sensex was at only about a year ago). Similarly, an outflow of approximately US$ 12 billon could depress BSE-100 by 30%, which may hover around 7,700 (the level where BSE-100 was a year ago).
  • Finally, our models and analysis show that a quick outflow of FII worth US$ 12 billion would also have a direct impact on the Indian Rupee, depreciating it by 6%. This will stoke inflation especially because India imports 75% of its crude oil, and most of the movement of grains, vegetables, and fruits across the country is dependent on petroleum products. Therefore, any rise in inflation may force the Indian government to squeeze liquidity in the markets, thereby hurting the Indian stock market both in the short and the long run.
Organization of the Paper

This article consists of seven sections. In Section 2, we discuss the growth of the Indian stock market between 1990 and 2007. In Section 3, we discuss the growth of the Indian economy, with special reference to three groups of sectors that have been growing - and are likely to grow - fairly rapidly. Section 4 discusses potential short-term risks while investing in the Indian stock market and also notes some similarities and differences with that in China. Section 5 compares and contrasts this current situation with some of the prominent “booms and busts” during the last decade in other emerging markets. Section 6 discusses some “silver linings” that exist because of the inherent growth in the Indian economy and that of worldwide liquidity, which is likely to continue for the next three to five years. Finally, we conclude in Section 7 by comparing and contrasting the arguments made in the earlier sections in favor of “bulls” and “bears” and using some of our models, back testing, and other analysis, we describe potential scenarios regarding the movement of the Indian stock market over the next few years.


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