Finance theory taught us that companies are valued based on the Net Present Value of expected future cash inflows. The market teaches us different. Valuations are undergoing massive ups and downs – from a high of 21,000 the Sensex crashed to 8000 levels in one cataclysmic year in 2008– and within two years of that, it's back to where it was. What happened in all the companies in the Universe to justify this? Nothing. It's all to do with global money flows.
Precisely the kind of money flows that caused the crash of 2008 are at work again. The US is back to printing currency and doling it out cheap. It has no option – its economy is not showing signs of coming out of the doldrums. So they are creating more money out of thin air and handing it out like free candy. Money coming in this cheap encourages hugely disruptive arbitrage behaviors. Everyone borrows and invests in assets, any assets, that will give them any kind of returns. The asset prices in turn are driven up due to all the demand; the fact that asset prices are going up ensures that they will go up still further since people start buying on expectations of further price increases. The Indian stock market has received 10 billion dollars of FII inflows in the last one month alone. This has resulted in keeping the Sensex where it is today, at above 20k levels, and also resulted in a huge appreciation of the Rupee. It is causing macro-economic imbalances as well, which are difficult to resolve.
At 44 to the dollar, exporters are hurting. The Rupee is overvalued and the RBI needs to bring it down. But to do this, they will have to inject liquidity into the market. More liquidity will result in interest rates falling when the RBI is trying to raise it to combat inflation in the economy. On the other hand, high interest rates are also partly the reason for more money flowing in, chasing returns! It's always a tough act, balancing interest rate, inflation, and exchange rate. At any given point in time, all three cannot be done.
Coming back to the asset price increases caused by cheap money – this is happening right across Asia. And the US is not the only culprit. Europe too is into the cheap money game. Valuations the world over are being driven by excess of money chasing assets, and not by their intrinsic worth. This includes the Indian Stock Market as well – the valuations currently look a bit stretched. What is stretched and what is not is debatable – there are theories doing the rounds that these levels are sustainable. However, such theories abound when the markets are going up – the livelihoods of most intermediaries in the market are dependent on creating hype.
What should make us worry is that liquidity that drives prices up is equally likely to reverse its flow and drive prices down. This happened during the last crash too – when money flows out, it is like pulling a plug at the bottom of a cistern – it just gushes out. Leaving in its wake a befuddled lot of bewildered investors who have only their cupidity to blame for believing in make-believe fairy worlds of ever-rising asset prices. Ironically, the money may go right back to the US to be parked there – it's called "flight to safety"! Which could result in the Indian rupee dropping steeply as well – remember the last time it touched 50? Again, that was during the crash.
How long will these prices sustain? Will they rise further? Will there be another crash in the US and Europe? How will their economies play out and what will be the impact on valuations here? No one knows. Everyone is just going along with the tide and enjoying the ride. Market players know that this is a grand party that may not last – but while it is on, it is not good to be absent from the party. Everyone is there enjoying their drinks while keeping an eye on the exit doors. If and when the crash happens, the rush to the exits will leave many dead and/or unable to get out in time. Whether it will happen, and when, no one wants to think about.
If you are in this party, be watchful. Keep your eyes on the exits and pray that you will be among the first few people who get out when the time comes. In the meanwhile, enjoy the drinks.
And quietly book some profits – it's always good to do that once in a while!