The stock markets: a repeat of 2008? - The Honest Truth By Ajit Dayal
Investing in India - Honest Truth by Ajit Dayal
The stock markets: a repeat of 2008? हिंदी | A  A  A

The question on everyone's mind: Is the BSE-30 Index headed for a collapse to the 8,000 and 9,000 levels of October 2008 and March 2009?

In November 2008 - when the Index was around 9,000 - I made a "prediction" or "forecast" or "view" that the BSE-30 Index could reach the 19,000 to 21,000 levels by July 2010. Well, rather than giving up on that view, I reiterated a more "bullish" view in July 2010 - when the Index was still 10% below my "failed" target - the BSE-30 Index could reach 31,000 by July 2012.

------------------------------------ 'The Honest Truth' now in Hindi also ------------------------------------
आपके पसंदीदा लेख अब आपकी भाषा में भी.
यहाँ पढ़िए.
क्या इस हिंदी अनुवाद में वही बात थी जो अजीत के मूल अंग्रेजी लेख में होती है?
इस हिंदी अनुवाद पर अपनी प्रतिक्रियाएं हमें ज़रूर बताएं.


A quick recap of the past 4 years
Between June 14, 2006 (a "low" caused by fears of higher interest rates in USA) and January 8, 2008, the BSE-30 Index surged from 9,063 to 20,873 for a +130% gain of 11,810 points. But there were 5 stocks that accounted for 55.2% of the gains in the BSE-30 Index were Reliance, ICICI Bank, L&T, Reliance Communications, and HDFC (Table 1).

Table 1: Who made the Index surge from June 2006 to January 2008
  Contribution to Index gain % of Index gain
Reliance Industries 2,422 20.5%
L&T 1,343 11.4%
ICICI Bank 1,327 11.2%
HDFC 738 6.2%
Reliance Comm 688 5.8%
Top 5 gainers 6,518 55.2%
Total gain of Index 11,811  
Source: BSE data, Bloomberg

From the 20,873 peak of January 8, 2008 the BSE-30 Index collapsed by -12,652 points (-61%) to the low of 8,160 by March 9th, 2009. The 5 stocks that accounted for 49.4% of the losses in the BSE-30 Index were Reliance, ICICI Bank, L&T, Reliance Communications, and HDFC (Table 2).

Table 2: Who made the Index fall from January 2008 to March 2009
  Contribution to Index loss % of Index loss
Reliance Industries (1,959) 15.5%
ICICI Bank (1,768) 14.0%
L&T (1,195) 9.4%
Reliance Comm (685) 5.4%
HDFC (643) 5.1%
Top 5 losers (6,250) 49.4%
Total loss of Index (12,652)  
Source: BSE data, Bloomberg

And we have now witnessed the market surge +140% from the March 9, 2009 low of 8,160 to the September 17th 2010 level of 19,595. The 5 stocks that accounted for 46.3% of the recent gains in the BSE-30 Index are ICICI Bank, Infosys, L&T, Reliance, and State Bank of India (Table 3).

Table 3: Who is driving the recent rally since March 2009
  Contribution to Index gain % of Index gain
ICICI Bank 1,282 11.2%
Infosys 1,180 10.3%
L&T 1,008 8.8%
Reliance Industries 992 8.7%
State Bank of India 827 7.2%
Top 5 gainers 5,289 46.3%
Total gain of Index 11,434  
Source: BSE data, Bloomberg

Is this a bubble?
No, not as yet.
For a bubble to emerge, you need to see the small caps and the mid caps surge.
Just as they did towards the end of CY 2007. That has not yet happened (Table 4). While the BSE-30 Index is 6.1% below its all-time high, the BSE Mid Cap Index is 19.9% below its previous peak and the BSE Small Cap Index is 26.7% below its all-time high.

Table 4: Not all peaked out
Index Peaked on Peak level Sept 17, 2010 level % below peak
BSE Small Cap Jan 7, 2008 13,975 10,239 -26.7%
BSE Mid Cap Jan 4, 2008 10,113 8,104 -19.9%
BSE - 30 Jan 8, 2008 20,873 19,595 -6.1%
Source: BSE data, Bloomberg

But it does not take long for small caps and mid caps to "get hot" and fire away. The BSE Small Cap Index doubled in 3 months from October 2007 to January 2008.

Is history about to repeat itself?
Stock prices are determined by two key variables:
  1. are the earnings of the companies growing? If earnings grow over time, then stock prices should increase over the years. But forecasting the future and estimating the earnings of a company is far from an exact science. In fact, though a lot of it is common sense, there are enough MBAs, CFAs, and PhDs who wish to find that magical formula to prove that it is a science.

  2. the extent and scale of the gain in share prices is a function of what people are willing to pay for them - and there is no correct formula that can determine how much an investor is willing to pay for every one rupee of earnings (the Price to Earnings Ratio, or PER), or for how long they are willing to pay that PER. Or what is the fair PER for the market or for a stock. Consider this: the historical PER (the price divided by the known, reported earnings - not the forecasted earnings) for the earnings of the BSE-30 Index was 19x in June, 2006 then surged to 28x in January, 2008 and fell sharply to 10x by October, 2008 before recovering to 22x in July 2010. So, people's "moods" change. The price that people are willing to pay for earnings of listed companies in the stock markets reflect these "mood swings" from "uncertainty" and "cautiousness" (when the market is "range-bound") to "optimism" and "greed" (a bull market) to "negative" or "fearful" (a bear market).
Mathematically, we could represent this as:
Share price = (Earnings and trust in management) X (what investors are willing to pay)
The first part of the equation ("earnings and trust in management") is, in my opinion, not that difficult if you have a long term time horizon for many companies in India. My optimism is intact - there are some pretty good managements and businesses out there which are still worth investing in.
If you watch companies and managements for a long time, over decades, there is a certain predictability of the "likely outcome".

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Some management teams will remain disciplined and focused on their business - and treat their shareholders fairly.

Some management teams will always find a way to take a "little extra" from what rightly belongs to all shareholders - in the hope that no one is looking. Or even if they get caught with their hand in the till, our greed as investors will ensure that our memory is short and all will be forgiven. Investors will come rushing back into their stock as soon as the "bull" market returns. After all, how can you not afford to invest in a stock that is rising?

Some management teams rely on the ignorance of even the smartest investors. "Haven't you become rich owning our stocks", they ask, "why are you worried about the details?" And so we get lulled into a trap that could be sprung on us anytime. Sometimes it may come in the form of a fax to the stock exchange as it did in the case of a Satyam.

As I said, determining the "direction" of the earnings and which managements to trust is, in my opinion, not the difficult part of the two-part equation of determining share prices.

Watch the flows - and control your greed
The big unknown is the second part of the above equation: "what investors are willing to pay".

I am a strong believer that the Indian economy is not that strongly linked to the fortunes of the global economy. Yes, there is a linkage - don't get me wrong - but India will not plunge into poverty and darkness if everyone in Europe and USA stopped buying goods today. In such an extreme scenario, China would have a real problem with its export factories shut down and India would head to a 5% to 6% rate of growth in GDP.

India's problem and linkage to the global economy is the money flows we rely on. While the underlying value of most Indian companies is not linked to the global economy, the price of these companies on the stock exchanges is set by the foreign investors. While most of the Indian mutual fund industry is still busy fighting for the rights of many distributors to earn opaque commissions - rather than focusing on winning investors - the foreign investors are busy investing in India (see Table 5) and have purchased USD 12.9 billion worth of Indian stocks since the start of the year. Many distributors - focused on earning commissions on the next ULIP product since SEBI has clamped down on their commissions from mutual funds - are busy advising their clients to sell their mutual funds. That accounts for the sale of USD 3.4 billion by mutual funds - this means that many investors have probably been wrongly advised! There will be some flow back of the money sold by mutual funds which will now come in via the ULIP route - minus the commissions that investors (unknowingly?) paid when being advised on this switch.

Table 5: Foreign "investors" play roulette from the cash being thrown by Helicopter Ben.
Period Net foreign Activity (US$ m) Net Local Fund Activity (US$ m) Total (US$ m) Change in BSE-30 TRI in that Period (% USD)
CY 2003 6,628 88 6,716 86.3%
CY 2004 8,669 -253 8,416 23.1%
CY 2005 10,707 3,049 13,756 42.2%
CY 2006 8,106 3,413 11,519 53.3%
CY 2007 17,655 3,222 20,877 68.5%
CY 2008 -11,974 2,501 -9,473 -60.7%
CY 2009 17,458 -1,132 16,326 89.7%
Cumulative 57,249 10,888 68,137 528.1%
August 2010 2,514 -682 1,832 -0.7%
YTD 2010 12,945 -3,402 9,543 3.0%
May 5, 2010 Greek Day -310 4 -306 -1.7%

But the point is that the money flows of the Foreign Institutional Investor (FII) will determine where share prices head in the near term. The Indian money is on the sidelines.

And that is the problem.
We have no idea what the foreign investor is likely to do - or when and why!

Will the FII invest more in India because they are scared of the economic situation back home in Europe, Japan, UK, and USA? The FIIs did that in September 2007 - just after the now-failed Bear Stearns allowed one of their hedge funds to go bust. FIIs pumped in USD 6 billion in 4 weeks then, this caused the market to surge - and led to the peak of January 2008 and then the slide before the crash in October 2008 as the FIIs changed their views on India and other emerging markets.

If interest rates were to increase in the USA to 5% (not likely in the very near term, but that is a guess) will FIIs decide that they would rather keep their capital in US government bonds and earn a safe and steady rate of interest? If they wanted safety and a 5% return, they could sell out of India - and cause the market here to decline sharply.

What if the pensions and long term investors in Europe, Japan, UK, and USA are not allowed to invest outside their home countries? Far-fetched? Guess what President Obama is doing now - making "Made in America" a requirement on the label for products and for companies to get tax breaks. In 1972, the UK government imposed capital controls when the UK had an economic crisis. Government could impose a higher rate of taxation on capital gains on "foreign investment" that subtly discourages foreigners from owning stocks in India and other emerging markets.

Yes, it is far easier to predict the earnings of companies than it is to predict what the share price - or Index - will be at any given point in time.

So should I buy shares now - or sell?
I don't know your individual situation or your individual finances.
But use this as a base case and then change the allocations to suit your needs and your willingness and ability to take risks.

As the Table 6 at the end of the article indicates, individuals should have exposure to different asset classes. It is advisable to calculate the money you need to spend every month for your family and the keep aside 12 months to 24 months of these monthly expenditures in a safe place like a PSU Bank. Then the rest of the money should be invested in stock markets, in gold, and in liquid funds or fixed deposits.

If you have invested in shares and the surge in price has seen your allocation to stock markets heads to, say, above 90% (against your target of 60%), it would make sense to sell some of your shares and re-deploy the money in gold or liquid funds. This "re-balancing" will allow you to ensure that you are selling your winners and putting money into the laggard asset classes.

If you don't have any equity shares at all, I would suggest buying into the stock markets over the next 12 to 24 months using a Systematic Investment Plan.

And the same goes for gold - if you have missed the run up in gold over the past 10 years, don't worry. Start buying some on a regular basis over the next two years. Gold, like land, is something you buy for a generation - not for one year.

No one has a clue how share prices move, but many may have a view on the direction of earnings over the next few years. And you should take advantage of that and buy shares for their future growth in earnings - not because the foreigners wish to buy or sell. Or because some of the distributors have convinced their clients to redeem mutual funds and buy ULIPs instead!

Suggested allocation in Quantum Mutual Funds (after keeping safe money aside)
Quantum Long Term Equity Fund Quantum Gold Fund
Quantum Liquid Fund
Why you
should own
An investment for the future and an opportunity to profit from the long term economic growth in India A hedge against a global financial crisis and an "insurance" for your portfolio Cash in hand for any emergency uses but should get better returns than a savings account in a bank
Suggested allocation 80% 20% Keep aside money to meet your expenses for 6 months to 2 years

Disclaimer: Past performance may or may not be sustained in the future. Mutual Fund investments are subject to market risks, fluctuation in NAV's and uncertainty of dividend distributions. Please read offer documents of the relevant schemes carefully before making any investments. Click here for the detailed risk factors and statutory information"

Disclaimer: The Honest Truth is authored by Ajit Dayal. Ajit is a Director at Quantum Advisors Pvt. Ltd and Quantum Asset Management Company Pvt. Ltd. The views mentioned above are of the author only. Data and charts, if used, in the article have been sourced from available information and has not been authenticated by any statutory authority. The author, Equitymaster, Quantum AMC and Quantum Advisors do not claim it to be accurate nor accept any responsibility for the same. Please read the detailed Terms of Use of the web site. To write to Ajit, please click here.

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39 Responses to "The stock markets: a repeat of 2008?"


Oct 2, 2010

Hindi version is equally good,more appealing sometime.Bulbula leaves more impact than BUBBLE, Similarly GOTA is more impressive than DIP OR FALL, JUA(JUWA) is certainly makes more impact than roulette or gambling.



Oct 2, 2010

Well researched, analytical and useful.
Please keep up!
thank you!



Oct 2, 2010

A nice article on FIIs.

I have a basic question on FIIs. Have they, as a class of investors, made any decent money in India? They were buying in 2007 like there is no tomorrow and they were selling like crazy in 2008 - exactly opposite to what any value investor would do. To some extent, they also suffer the curse of a big player - when you buy, the price goes up and when you sell, the price comes down. Also, the Indian market is not deep enough for them to buy low and sell high. But, their euphoria in 2007 and panic in 2008 is inexplicable. But, as value investors, that is exactly what we are looking for.

On ULIPs, so long as our people are confused between insurance and investments, these kinds of things will keep happening. The mutual funds are not guilty of confusing people in that respect certainly.



Sep 30, 2010

Hindi should be nurtured and given importance, but this is true for any Indian language.
Also, some of here say that Hindi is a National language. This is wrong. There are 14 National languages of India. And all of them can be spoken in Indian Parliament.
Hindi (and English) are two official languages of Indian Government.
People just "assume" that Hindi is the only national language. Please read the Constituition of India.

Please don't mistake me, I know Hindi. It is just that too much importance to Hindi, at the detriment of other Indian languages, is also bad for India.



Sep 28, 2010

Let a sharp correction do some job. Moreover this is the very first time there is a severe silence in the political circle which I don't understand.

The Indian Politics is somewhat boring without the usual parliament clashes and MPs verbal fights and so on. No budget talks and no horse trading in political play ground.

Once if everything surface then our Market will show its true color



Sep 28, 2010

Nice commentary and lucidly explained.

Everyday we hear that FIIs have been net purchasers and DFIs have been net sellers. The MFs have seen redemptions. Where does this money go? Has it been parked in Gold / Real Estate or just lying in bank lockers or adds up to the liquidity that RBI is trying to control? Is the inflation a result of this excessive money that is being used for increased consumption? Will this contribute to the growth of GDP? Will this also mean that FIIs will have a greater clout on Indian Economy than the DFI (public sector and indirectly Govt of India)in future? Is a housing bubble building up in India - domestic units in great demand but commercial space is still down in terms of prices? When the FIIs withdraw will there be a payment crisis for those who are left with large number of unpaid EMIs for houses and consumer durables? If business does not grow - as hinted by continued slump in commercial property - the payment crisis for individuals may not be too far. Request your views on this.


Bhavesh Sanghvi

Sep 26, 2010

Nicely explained Ajit, but whats it got to do with ULIP's, i didnt really get that part. Against all the hoopla and noise against ULIP's , i believe they are the best thing that happened to the insurance industry. The products are transparent, doesnt allow any cross subsidization across policyholders money. Yes some ULIP's were indeed expensive and some were dirt cheap, its the greed of the distributor and irresponsibility of the buyer that lead to people buying products which paid the distributor 40% commission's, well the smarter one's did get that back through rebate. The mutual funds are no gods themeselves, some paid 6% commissions when they launched the international funds, nfo's etc. Look at LIC, its a loot, wonder why dont you or a valueresearch write against the conventional / traditional endowment schemes as compared to ULIP's. LIC pays 40% commission and the IRR on the investment portfolio is not more than 4%, its a rip off. At least ULIP's dont do that.


sunil kumar singhvi

Sep 26, 2010

Dear Ajit
Nice Article . Your initiative of Hindi translation deserve appreciation . It conveys same message as yoou tried in english . Hindi translation will be very useful for people who are not very proficient in english . I hope your future articles will also be translated in Hindi .
Kudos to your team who did this work


MNG Pillai

Sep 25, 2010

Although infusion of funds by FIIs is a reason for
wide flucuation in stock market; the factors like
climatic conditions, govt. policies and even the stability of Govt. etc. cannot be over looked. Historically, our market is in a growth path.
A thought provoking analysis. Congrats..



Sep 24, 2010

Dear sir,
your article is very good,it helps us for investment planing.A well researched and interesting write up. I wish your views gets the recognition it deserves .

Thanking you

vinod choudhary

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