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Suresh Krishnamurthy

Trading volumes in the stock market have risen sharply. Investors need to be wary as such rising volumes have fuelled market excesses in the past.

MARKET operators must be bursting with optimism. The feel-good factor appears to be in full swing, as the rising trading volumes suggest. Delivery volumes in July rose by almost a third over June while trading volumes increased by a fifth. The market is awash with liquidity, fuelling the stock price surge.

Liquidity, however, is also a sign that value-seekers need to be cautious. It can drain out of the market in no time and that could burn a hole in your pocket. Fortunately, stock prices are not excessively overvalued now and this reduces the risk of large losses. Nevertheless, beware of liquidity. It is the fuel for excesses in the market.

Price premium: The market price of a stock can be seen as consisting of two components — its intrinsic value and the liquidity premium. When market prices fall, the liquidity premium may even be negative. When market prices rise, the liquidity premium will be positive.

It makes sense to buy when the liquidity premium is negative. That increases an investor's margin of safety. To buy when the liquidity premium is positive reduces your margin of safety. This increases the risk of loss which, then, reduces your expected returns.

Liquidity premium can be viewed as a function of risk preference of investors. When investors perceive higher risk, investors demand higher returns and liquidity premium is low. On the other hand, when investors perceive lower risk, they demand lower returns and premium is higher.

Going overboard: The question is if investors are justified in factoring in reduced risks now. Admittedly, a number of factors are in their favour.

The monsoon has been good, interest rates are as low as they have ever been and economic growth is picking up. Earnings growth rates are likely to go up and there is strong justification for share price increases.

However, it is in very similar circumstances that investors have gone overboard in the past. Quite rightly, they bid up the share prices. But, in their euphoria, they are prone to bidding up the shares too high.

This has happened too often in the past in the last decade. The market excesses of 1992, 1996, 1998 and 1999-2000 are a few examples.

This has happened in the development market too. Research in the US indicates that due to liquidity, prices can even run up to two times the intrinsic value of a stock. For example, if a stock's value is Rs 100, its price can rise to even as high as Rs 200 before starting to decline.

Suitable action: Now, in India, prices are yet to soar to such extremely high levels. The economy is at a crossroads. The growth curve of the economy can easily traverse into a higher trajectory, justifying the present higher price levels.

However, if liquidity keeps flowing into the market, stock prices will move beyond even optimistic values and into a trading range. When the stock price is ruling in such a range, fundamental factors would matter less.

Retail investors should be wary of participating in such a market. A stock bought because of its attractive fundamental factors, such as high expected returns, should be sold if it is no longer attractive based on such factors. Driven by liquidity, the stock price may rise still further. However, that should be of no concern.

The stock is no longer an investment proposition. Staying invested would be a trading call. Trading calls may or may not be suitable to your objectives.

Investors need to scale down their return expectations too before buying into the market now. Relatively larger earnings growth rates will be needed to deliver double-digit returns.

If such earnings growth does not materialise, the returns would be in single digit. But then, single digit returns are per se not bad. If stocks fetch 8 per cent when bonds yield 5 per cent, it should be considered par for the course. These are good times, and they usually yield lower returns.

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