July 2009

Equity markets continued to be strong during the month, in line with global markets rather than this being just an Indian phenomenon. Globally, the quarterly results was received with a sense of optimism by the analyst community. Though results on an absolute basis have been poor, stocks have rallied as several company results were ahead of expectation. This is one of the strange aspects of the investing world, as the average company’s growth and profit expectation is far from their 2008 peaks. Much of the current global equity rally is more on optimistic expectation from the future, rather than current realities.

One of the unique aspect of the current rally is that it is mostly sponsored by the governments. Governments across the world have told themselves that they will continue to borrow and infuse stimulus into the economy till the day the individual country economies are firmly on a growth track. Most large economies are borrowing more than 10% of their GDP annually now, compared with a 2-4% historically. The after effects of this medicine can last a long time – which is the bigger worry. After effects include high inflation, liquidity dry up and a protracted period of high tax rates. I am sure one knows what happens to people who live on borrowed money for long.

Over the past few weeks, several companies have been raising large amounts of money through one of the quickest routes of raising equity funds – Qualified Investor Placements. Most of these companies are raising money are prices levels that are significantly lower than the historical high prices. Promoters are willing sell parts of their company, at lower prices. This willingness to quickly raise funds indicates some concern among managers that the window of opportunity to raise funds may be short. Why else would one see such a huge queue to raise money at prices much lower than peak prices.

The key question to address now is – is the current rally in equities a start of a sustainable long term equity market rally, or a temporary rally that may fizzle out soon. Firstly, the key catalyst for this rally has been government stimulus and borrowings, which need to be reversed soon. Secondly, corporate results in India seems to have reached a cyclical peak and have started to reverse. We have not seen too many companies that have the same optimism on the future as they had in 2007. Thirdly and most importantly, stock prices of larger companies are not cheap any more. Several companies are trading near the top end of their historical valuation range. In this context, it seems highly likely that this rally cannot sustain into a sustainable bull market.

Though there are several negative news lurking around, equity markets are ignoring all and looking only at the positive possibilities. Risks are not getting priced in. This is an opportunity to reduce exposure to equities and wait for a more opportune time when markets take on a more balanced view on economic conditions.