With the Sensex almost doubling in six months, the worry is if investors are overtaken by excessive optimism.

In a mere six months, the mood in the stock market has swung from unrelenting gloom to sunny optimism. When the stock market rally began in March, it was a case of prices ‘reverting to mean’ from extreme pessimism. The initial leg of the rally did have strong moorings in fundamentals, backed by resilient domestic macro-indicators and the improving corporate earnings picture. However, six months down the line, with the Sensex almost doubling, the worry is if investors are overtaken by excessive optimism.

If Indian stock prices offered a bargain in March, valuations have now moved into the expensive zone from a historic perspective. Though the Sensex, at 16,000, hovers at the same absolute level as in June 2008, it is more expensive in PE (price-earnings) terms. Today’s index discounts the trailing earnings of its companies by nearly 21 times; much higher than 16 times last June. The market bellwether’s valuation is already above the comfort zone of its long-term average (about 17) and isn’t too far away from levels where the previous bull run culminated. That the Sensex PE multiple has doubled from March, suggests that earnings haven’t kept pace with stock prices; it appears to be more a case of expectations about the future fuelling the recent gains. It is surely a disconcerting sign when market players use technical arguments (a function of momentum) or the prospect of upward revisions in earnings over the next two years (by no means a certainty) to justify fancy Sensex targets.

Indian investors have to exercise much more caution than their counterparts elsewhere in the world. Not only is the Indian stock market now among the most expensive in the world, it is also too reliant on the munificence of foreign investors for liquidity. Given that this entire rally has been driven by global investors reallocating funds from safer options back home into the emerging markets, the question is whether these inflows will continue, even as the US or European stocks now appear much cheaper. All this does not imply a prediction that the ongoing rally is set to end soon. Certainly no one can tell how long liquidity flows may continue or markets remain expensive, before the next round of mean reversion sets in. What can be said though is that it is always useful for investors to know when valuations are stretched. On all accounts, they are now.

Related Stories:
Sensex breaches 16K

(This article was published in the Business Line print edition dated September 9, 2009)
XThese are links to The Hindu Business Line suggested by Outbrain, which may or may not be relevant to the other content on this page. You can read Outbrain's privacy and cookie policy here.