The first full week of 2010 did not bring in much cheer for Indian investors. The BSE Sensex trailed global markets, in rising just around 0.4% during the week (ended Jan. 8). High overall valuations remain one of the biggest concerns that investors have at the start of this year. As a matter of fact, the Sensex P/E currently stands at around 22.5 times. This is almost double the level the index was trading at a year back.
Apart from these valuation issues, another concern investors have is of the sustainability of the economic recovery. In effect, we believe markets have become too dependent on unsustainable government stimulus. As The Economist says - "Something’s got to give."
A report in the publication reads, "The effect of free money is remarkable." It suggests that near-zero interest rates in the developed economies of the US, Japan, Europe have persuaded investors to take their money out of cash and to buy risky assets. Count emerging markets like the BRICs into this category of risky assets and the gains of last year will seem realistic.
After all, even you might take higher risk with the money offered to you at zero interest rate. Isn’t it? So what could leave the foreign investors behind? Experts give this the term – carry trade. In simple terms, it means borrowing at a cheap rate (in dollars as of now) and investing for a higher return (like in emerging market assets).
The dollar carry trade seems to be in fashion these days. Investors in emerging markets do not seem to be complaining at all. But what all this can lead to is a wider gap between valuations and the outlook for economic fundamentals in 2010. People have restarted taking higher risk assuming that the cheap money will continue to flow in. And some like the US central bank are only delaying the inevitable by promising to keep money cheap for an 'extended’ time.
Remember, it was this very cheap (and limitless) supply of money that had convinced the Americans to live beyond their means. That caused the subprime crisis!
Now if the central bankers think that this time it is different, and that cheap money can cure the problems caused by this very devil, rude shocks await them. And also for emerging markets where investors have given in to believe that they can buy any stock and the foreigner will come the next day to buy it from them at a higher price!
As The Economist concludes - "Today the prices of many assets are being held up by unsustainable fiscal and monetary stimulus. Something has to give."
We also believe that apart from a gush of cheap global money, what also matters is the underlying fundamentals of companies. And if those remain weak or are fully reflected in stock prices, then no matter how excessive the liquidity, buying stocks may turn out to be a dangerous proposition.
Investors could do well to remember this very important lesson from history, whose latest chapter has the year '2008’ inscribed in it headline.