The Hindu Business Line : New features of the stock market surge

With the BSE Sensex having settled above the 9000 mark, evidence of an unprecedented bull run on India's stock market is now incontrovertible. But similar trends in the past have been followed by an unwinding process triggered by news of market manipulation or fraud. This time around, however, both the Government and the regulator, after initially expressing caution, appear sanguine. C. P. Chandrasekhar and Jayati Ghosh examine whether there still is need for caution.

THE Bombay Stock Exchange Sensex has recorded an unprecedented rise in recent months. Having closed above the 5000 mark in July 2004, it crossed 6000 in the middle of November 2004, 7000 in June 2005, 8000 in November 2005 and stood above 9200 on December 16, 2005 (Chart 1).

This 82 per cent rise over 17 months and 53 per cent rise in over a year are indeed remarkable even by the standards of the post-reform years.

It is well recognised that stock market buoyancy and volatility have been phenomena typical of the liberalisation years.

Till the late 1980s, the BSE Sensex graph was almost flat, and significant volatility is a 1990s phenomenon, as Chart 2 shows.

A closer examination of trends since 1988, when the recovery began, points to extreme volatility in the Sensex during the liberalisation years (Chart 3). And judging by trends since the early 1990s, the recent surge is remarkable not only because of its magnitude but because of its prolonged nature.

Those acquainted with the recent history of the market, however, know that most peaks in the volatile 1990s were the result of market manipulation of one kind or another, amplified by the role of foreign institutional investors (FIIs) which have discovered the Indian market since liberalisation and targeted the country with large and volatile flows.

Volatility is, of course, a result of the structure of India's financial markets. Markets in developing countries such as India are thin or shallow in at least three senses.

First, only stocks of a few companies are actively traded in the market.

Second, of these, only a small proportion is routinely available for trading, with the rest being held by promoters, financial institutions and others interested in corporate control or influence.

And, third, the number of players trading these stocks is few in number. The net impact is that speculation and volatility are essential features of such markets.

But any explanation of the post-liberalisation trends must also focus on some changes in the structure of India's stock markets during the 1990s. As part of its policy of financial liberalisation, the Government decided in 1993 to permit FIIs to make portfolio investments in India's stock markets.

Given the huge funds at their disposal, even relatively small investments by FIIs meant big money for stock markets in countries such as India. At the margin, the impact of FIIs on domestic markets is much greater than suggested by their share in capitalisation.

Further, FII investments are also motivated by a desire to trade actively in pursuit of capital gains. This has forced the domestic financial institutions to take note and respond. As a result, their trading activity has also increased substantially.

This new revival in trading is, however, in relatively large lots and confined to the shares of dominant companies. This has two implications.

First, it increases the volatility of the Sensex.

Second, movements in the Sensex do not capture the state of trading in the market as a whole, and conceal the fact that segments of the market like that for primary issues have virtually dried up.

Liberalisation and the entry of FIIs affect market behaviour through their implications for economic policy as well. FIIs, whose exposure in Indian markets is an extremely small share of their international portfolio, pursue international investment strategies that could involve periodically investing in or withdrawing from India.

This forces governments keen on attracting and retaining their investments to bend over backwards to appease them.

A corollary of this influence of FIIs is that any market player who is able to mobilise a significant sum of capital and willing to risk it in investments in the market can be a major influence on market performance.

For example, revelations of fraud, evidence of insider trading and a consequent collapse of investor interest led to an almost unstoppable downturn in India's stock market after the presentation of the 2001 Budget.

This link with the presentation of the Budget was not coincidental, since the concern with attracting foreign capital flow has been reflected in the Government's post-liberalisation fiscal, monetary and financial policies.

And Budgets have been framed with the intent of not just satisfying financial investors from abroad but of attracting them by keeping financial markets buoyant.

The spoken responses of financial agents and the activities, as reflected by market indices, were therefore seen even by the Finance Ministry, and not just by the media, as an indicator of success in Budget formulation.

This meant that the pressure to please financial players has played a major role in shaping recent Budgets though, given the whimsical demands of finance, success is never guaranteed.

Paradoxically, for the speculator in the stock market, this has provided another counter to bet on. Would the Budget trigger a sharp rise in financial markets, however short-lived, or would it not?

Differing answers to that question would elicit different speculative responses. This was the question which Ketan Parekh, the most recent incarnation of the perennial `big bull' in India's stock markets, had set himself and answered in the positive in February 2001. What ensued is now history.

Given this role of the FIIs in the market, it is not surprising that the recent spurt in the market has been associated with an unusual intense interest of foreign investors in Indian markets (Chart 4).

The question that arises is whether this trend has been accompanied by any other tendencies which could make the current boom different from previous surges.

A notable feature of previous surges was the presence of individual manipulators, such that any post-1990 history of the stock market would be replete with names of "rogue" players such as Harshad Mehta, Chain Roop Bhansali and Ketan Parekh, besides domestic and foreign banks and institutions.

The nature of the scam in each case involved, therefore, two sets of issues: first, the source of the large funds needed to indulge in the scam; and second, the specific way in which the market had been manipulated.

More recently, however, the role of individual players in determining surges and slump seems to have receded, even while speculation plays a role. Consider for example Black Tuesday, April 4, 2000.

The BSE Sensex, which closed at 5,052.94 points the previous day, collapsed to an intra-day low of 4666.95, and recovered only marginally to 4691.46. This single day loss of 361 points was reportedly the "seventh largest single day loss in India's capital markets", and the highest decline since the stock market scam of the early 1990s.

However, unlike earlier episodes of collapse which came in the wake of an engineered, speculative boom in the stock markets, this time around there was no obvious scam to nail, though the volatility in the markets on, prior to and after that day suggests that speculation ruled India's financial markets.

Virtually ignoring the obvious role of speculation, the Government set about searching for reasons to explain market nerves, so as to respond to them. Two came in handy.

First, notices served by the Income-Tax Department on a set of FIIs, demanding payment of close to Rs 9 crore in view of their avoidance of capital gains tax.

And, second, signs of a collapse of a similar boom in the Nasdaq, the New York index of high-tech stocks.

In a similar vein, the absence of individual "rogue investors" responsible for episodes of speculative booms in the market is encouraging the Government to ignore the speculative element in the recent surge in the market. Government spokesmen who were earlier making a case for caution are now treating the surge as normal, on the grounds that it is being driven by improved corporate performance.

Two kinds of numbers are being quoted to defend such an argument.

First, it is being argued that the performance of manufacturing and service companies has recorded remarkable improvement, warranting higher stock prices.

And, second, that the effects of this are reflected in "comfortable" price-earnings ratios, even as stock prices are registering remarkable increases.

This view is to an extent exaggerated. As Chart 5 indicates, the surge in the Sensex in recent months has indeed been accompanied by a rise in the price-earnings ratio. In fact, the two graphs show very similar movements.

However, a P/E ratio of 17.5 is relatively low, and it is even lower than levels it had touched in December 2004 when the Sensex was much lower.

In fact, a puzzling feature of recent trends in the market is the relative movement of prices and earnings.

Chart 6 provides a comparison of price to earnings and price to book value ratios since the early 1990s. It shows that, while in the past these ratios tracked each other quite well, more recently the ratio of price to book value has raised ahead of the price-earnings ratio, resulting in an unusual divergence. In fact, the price-book value ratio which was below the price-earnings ratio has now risen well above the latter.

The implication of this should be obvious. Corporate performance has improved so remarkably in recent months that despite the price surge, the price-earnings ratio has remained at comfortably low levels. The puzzle then is the remarkable rise in corporate earnings.

It is indeed true that the Index of Industrial Production does point to an improvement in manufacturing performance in recent months. But that in itself cannot explains such a sharp improvement in earnings.

In fact, there appears to be no relation between the movement in the manufacturing IIP and the Sensex over the decade as a whole.

There must be other factors driving the boom, therefore. What is crucial is that this should not include the manipulation of accounts aimed at driving up stock prices, with the aim of using high stock market values to issue new capital at a premium and substantially bring down the cost of capital. If it is, then the recent spurt of FII investment driven by attractive P/E ratios could go bust on revelations of irrational exuberance driven by inflated profits.

We must recall that the late 1990s boom in the US stock market was sustained through accounting fraud that afflicted even leading companies and the subsequent crash was spurred by revelations of such fraud. Charges of accounting fraud have been levied against Enron, Adelphia Communications, Tyco, Peregrine Systems, Global Crossing, WorldCom and Parmalat among others.

The following quotation from a New York Times report is instructive: "The fraud went on and on for more than a decade. The auditors never noticed. That was the image that emerged... as Italian investigators said they had learned that Parmalat's fraud began more than a decade ago, around the time the company went public in 1989 and long before it became Italy's largest food company.

"The collapse of Parmalat has produced inevitable comparisons to Enron, which, like Parmalat, used related companies in the Cayman Islands and elsewhere to hide some of its odd transactions. But the closer comparison may be to CUC International, which held the title of largest American accounting fraud until it was eclipsed by the wave of frauds that have come to light in the last two years.

"CUC International, formerly known as Comp-U-Card, grew rapidly through the 1980s. Extensive fraud there, which involved inventing most of the profits the company ever reported, began about the time the company went public in 1983, according to former officials who have since pleaded guilty to fraud charges. It led to what was called the largest accounting fraud ever when it was finally exposed in 1998."

India has successfully, even if prematurely, absorbed much from the West: rapid services growth, an IT spurt, and a dotcom boom and bust to name a few.

Hopefully, accounting fraud to trigger stock price inflation is not among them.

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