Watch your money: This isn’t the time for Sensex bravado

The vertical drop in the index of industrial production (IIP) in August is a fortuitous wake-up call for the stock markets and retail investors.

Both must take heed, as the Sensex’s heady levels cannot be sustained indefinitely. We are probably at the cusp of a mood swing because the market euphoria has been built on water, not cement.

The indices have soared on the basis of sheer liquidity — more cash chasing more stocks.

Look at the numbers. Over the last two years, the index has risen from a low of 7,697 in October 2008, to more than 20,000 now.

That’s a near 160% rise when the economy has grown at an annual 7-8%. Between January 2010, and now, the index has risen 25% powered by an extraordinary Rs100,000 crore surge of hot money from foreign institutional investors (FIIs).

On the other hand, domestic investors have been fleeing stocks. If mutual funds can be seen as a proxy for retail money, they have sold over Rs25,000 crore worth of stocks this calendar, pressured by redemption pressures. Clearly, foreign investors are buying the India story more than Indians.

This is not to say that the Sensex will crash tomorrow. It may do just the opposite, now that it has sniffed the all-time high of 21,206 of January 2008, as a possible assault target. But consider this: when all asset classes are at stratospheric levels, how can anyone assume that the party will go on forever?

Stocks, real estate, gold and fixed deposit rates are all rising simultaneously and something has got to give. I am not betting that bank deposit rates will fall. It has to be the other assets.

The underlying truth is that the global financial collapse of 2008 fuelled compensatory asset bubbles in the economies still standing, especially India.

We are the market most suitable for hot money flows. We are getting all this money by default because the US, Europe and Japan are mired in self-doubt. China’s economy should actually attract even more than us, but the Middle Kingdom’s policy of keeping the yuan undervalued worries investors.

Moreover, China doesn’t need these flows as much as we do. China is sitting on over $2.5 trillion in foreign exchange reserves. India, with its huge current account deficit — the gap between imports of goods and services and exports — is sucking in the money by the truckload.

What if this is reversed? No country can afford to sustain a current account deficit of 3% of GDP for long as it is tantamount to buying more from the world without selling enough to pay for the import bills. This is why the US is so much trouble.

Sooner or later, the Reserve Bank will have to let the rupee slide to help exporters, and foreign investors will see their dollar returns falling like a stone.

The RBI is in a lose-lose-lose situation. If it lets the rupee slide, inflation will rise. If it doesn’t, exports will fall or stagnate, bringing overall growth down. If it does nothing, hot money inflows and outflows will destabilise the real economy when it is least expecting it.

The market is living on borrowed time because all the positives are already taken for granted: the India growth story, lower inflation after a good monsoon, a better fiscal scenario (after the 3G spectrum auction bonanza), heavy capital inflows, et al. This is simply too good to last. So when will the tide turn?

Is the dramatic drop in the IIP one signal? Is the fall in capital goods growth from 72% in July, 2010, to -2.6% in August another warning? The IIP’s fall from 10.6% in August 2009 to 5.6% this year is being explained as being the result of the base effect: growth on the higher IIP numbers of last year tends to depress this year’s numbers. But this cannot be the only explanation.

With the festival season now upon us, the high growth in asset prices — stocks, real estate and gold — may make people spend more, but it may take only a small reversal in FII flows to change the whole mood. When asset prices rise, the wealth effect (we feel rich when our investments rise in value) makes us eager to spend. When the reverse happens — when the bubble is pricked — people will suddenly stop spending, pressuring the growth figures down.

Another negative is the large overhang of initial public offerings (IPOs), especially mega issues like Coal India’s Rs15,200 crore one. The chances are investors will sell the stocks they currently hold to invest in IPOs — and this could dent share prices. It’s also worth noting that few of the recent IPOs have fared too well on listing. This shows that promoters have been too greedy, leaving little on the table for investors.

Net-net: This is not the time for stock market bravado. Those who invest regularly through mutual fund systematic investment plans (SIPs) need not stop investing just because the Sensex is high, but anyone planning to enter the market at current levels runs the risk of losing a part of his money. If the FIIs bolt in November and December, the markets will go for a toss. Be warned.