Foreign institutional investors' (FIIs) net investments in Indian equities crossed US$ 8 bn in mid-2009. Last year, hit by recession back home FIIs had withdrawn nearly US$ 12 bn from the Indian stock markets, only to bring most of it back this year. With FIIs holding 16% of India's biggest 500 companies, experts believe the FII holding may soon rival the 19% peak seen in 2007. This is as the third-largest Asian economy continues to grow at a decent pace. However, we believe that there is more to it than India's growth. There is no denying that even at an average of 6.5%, India will grow at double the growth rate of world's largest economies over the next 3-4 years. However, it is not just a case of India doing too well. It is more a case of the developed economies, particularly the US, not doing well.
Further, investment analysts and credit rating agencies in the US are no more in a position to hide the economy's weaknesses. An article in The Daily Wealth explains why US economist Stephen Wright considers the current valuations of S&P more overpriced than it has ever been except for the peaks in 1929, 2000 and 2007.
The basis of this conclusion are two valuation indicators, namely - the Cyclically Adjusted Price Earnings (CAPE) and the 'q'. While CAPE is very similar to the price-to-earnings (P/E) ratio, its takes the average earnings of the past 10 years to smoothen the impact of booms and busts on earnings. The 'q' is a ratio of stock prices to asset values. While the price-to-book value (P/BV) ratio takes the ratio of stock price to book value, the 'q' replaces the book value with the replacement cost of the company's assets. This is because replacement cost is closer to reality than book value as it reflects price inflation. These indicators when plotted for over a 100 years show the US stock market is currently as much as 2.5 times overvalued than at the end of 1998.
Hold on! There is more to it. While the CAPE showed the US markets were overvalued by 37% at the end of October 2009, the 'q' showed the market was overvalued by 41%. While the latter could be the result of lower replacement cost of assets after the real estate meltdown, the beaten down earnings of US corporates in 2008 and 2009 are certainly taken care of by the CAPE.
Rating agencies like the S&P and Moody's that were so far silent over the AAA status of the US despite the economy's burgeoning fiscal deficit are also changing their stance. They have cautioned a rating downgrade in case the economy fails to correct its fiscal status.
Thus the FIIs have fewer choices to begin with. Either they stick to investments that offer them safe near zero yields (US Treasuries, bonds) or put their money in US stocks that (with the exception of a few) could eventually erode even the principal, leave alone returns. The other option is to put their money in emerging markets that can safely offer them returns in excess of 6-7%, even after factoring in all the political and economic risks associated with them.
Thus the FII inflows may remain intact in the medium term. However, the concerns over the same creating an asset bubble in India need to be ironed out. As the RBI Governor Dr. Subbarao recently put it, "Capital is flowing in because India gives them (the FIIs) confidence. We have to learn to manage capital flows when it comes, and as it comes".