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Does economy need the bull run?

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The current global perception seems to be that the sustained bull-run is not due to any "irrational exuberance" but a vote of confidence in a resurgent India. But rapidly rising stock prices are neither necessary nor sufficient for boosting economic growth, says Alok Ray

Economy needs more than market exuberance. Thomas Rocha
Economy needs more than market exuberance. Thomas Rocha

Alok Ray

THE Sensex is crossing one milestone after another. The common refrain is: Has the Sensex gone out of control? It took the Sensex just 40 days to jump from 7000 to 7900, and 79 to move from 6000 to 7000. The runaway rise in global oil prices, the Bombay High disaster and the recent disinvestment fiasco do not seem to have dampened the buoyancy of the stock market.

How does one explain this sustained bull run? There are no doubts about the proximate cause. Over the first seven months of 2005, overseas investors have pumped in $7.3 billion into the bourses nearly 10 times the amount invested by Indian mutual funds.

This implies that the stock market boom is basically driven by foreign funds. Local investors have either stayed away or are mostly selling (booking profits) while the going is good.

None is sure when this bull-run will end; it has to at some point. Typically, on any given day, investors buy and sell, as each one has different expectations about the future. The market going up or down depends on the net effect of the demand-supply pulls. In the current "bull" run, those who believe the market would go up further clearly outnumber those who think otherwise. But why such optimism?

Are there no objective methods to judge the true worth of a stock, that is, whether the current price is far removed from what the "fundamentals" of a company point to?

Well, investment analysts compute, among other things, the price-earnings (PE) ratio, which measures what one currently pays to buy a stock relative to the future expected earnings from holding that stock. After all, the aim is to maximise returns from one's investment portfolio by choosing from alternative assets.

The PE ratios are compared for similar companies in other markets to check whether the stock is over- or under-priced. But this is an imprecise guide. Further, if a particular market is likely to deviate sharply from the past, then looking at the past/present data may not give an accurate picture of future returns.

Some analysts believe that precisely such a thing is happening in India. After China, India is, perhaps, the next best growth story. China is the preferred destination for foreign direct investment (FDI) but not so for FII money.

Given the regulations, it is neither easy for foreigners to invest in the Chinese stock market nor for them to come out quickly. So, compared to China, the Indian stock market is a much bigger draw for foreign investors.

The current global perception is that India has reached a stage from where it will be able to sustain a higher growth rate. For those who set store by this `New India', the sustained bull-run is not due to "irrational exuberance" but a vote of confidence in a resurgent India.

This euphoria has been accentuated by a new class of investors, who so far watched from the sidelines. The high-saving Japanese have a lot of funds to invest, but the slowdown in Japan, the low growth in Europe and the rather uncertain economic prospects for the US (due to the massive fiscal and trade deficits) have made them look for other options. The Japanese are generally more cautious than others, but now that the new India story seems real to them, they are investing in a big way.

With many Indian companies posting high and rising profits, foreign investors feel that they can earn a higher return and/or reduce the overall risks on their investment portfolios by including Indian assets in their basket.

Irrespective of the source of funds, Indian companies are embracing them.

The FIIs can invest up to 24 per cent of the paid-up capital of an Indian company. Since the FIIs are quite close to this limit in many blue-chip companies, several firms are passing board resolutions to raise the ceiling.

After exhausting the permissible limits in blue-chip companies, some FIIs are now expanding their focus to lesser-known corporates, making the stock market rally even more broad-based.

Should small investors invest at this point of time? Even a high rate of dividend may mean a small rate of return if a stock is bought at a high price. Suppose, a Rs 10 share of Company X is bought at Rs 400. And, say, the company declares 100 per cent dividend. This would mean one gets Rs 10 by investing Rs 400, which works out to an annual rate of return of only 2.5 per cent. Of course, the returns would be higher if the share is sold for more than Rs 400 a year hence.

But, then, there is always the possibility of capital loss if the price falls below Rs 400.

In fact, theory suggests that one cannot consistently beat the market. So, if the stock market is "efficient" (meaning, the current prices of stocks factor in all publicly available information), there will be no profit opportunity to exploit. If some new information appears about a company's future profitability, knowledgeable investors would rush to buy the stock. This would immediately raise the current price, exhausting the potential gains from buying the stock.

If some investors consistently make money from the stock market, then they either have some inside information (that is why "insider trading" is illegal) or are plain lucky. Experiments show that a portfolio of stocks chosen by a chimpanzee at random have performed no worse than those carefully chosen by "expert" mutual fund managers. The reason mutual funds give a fairly stable positive return over the long run is due to the diversification effect of the pooling of a number of different stocks.

So, the best bet for an ordinary investor is to invest in some broad-based mutual fund on a long-term basis and not go for a quick kill.

How is the real economy going to be affected by the booming stock market? One major problem is that the continuing inflow of overseas money is strengthening the rupee and, thereby, affecting the competitiveness of Indian goods and services.

The trade gap has widened to $3.99 billion, up from $2.5 billion a year ago. Despite the cushion of more than $140 billion of foreign exchange reserves, the Government cannot but be concerned with this development.

It would like to depend more on the stable flow of export earnings and FDI inflows and less on unstable FII money to shore up the balance of payments.

One should not forget that economic growth basically depends on new investment and the productivity of such investment.

Stock market boom primarily means rapidly rising prices of existing stocks, and this is neither necessary nor sufficient for economic growth.

(The author, a Professor of Economics at IIM Calcutta, is Visiting Professor of Economics, University of Rochester, US.)

(This article was published in the Business Line print edition dated August 24, 2005)
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