Financial Daily from THE HINDU group of publications
Wednesday, May 24, 2006
Opinion - Stock Markets
Markets - Insight
A sign of the times. Paul Noronha
Several hours before the stock markets opened on Tuesday, there were many who suggested that stocks would trade at prices higher than Monday's, especially if the market opened weak. The market did indeed open with a frightening crash. And then it closed higher. The Sensex closed 3.25 per cent over Monday.
The S&P CNX Nifty closed higher by 3.83 per cent. It closed a few decimals short of 3,200. In particular, 44 of the 50 stocks that comprise the S&P CNX Nifty closed higher. These include equities of commodity and technology companies, and of consumer goods and consumer durable makers. It would be normal in such circumstances to believe the worst is over. Perhaps, the worst is over. But the relief should not fuel another round of optimism. It would be daft to expect the S&P CNX Nifty to rebound to 3,774 its 52-week and all-time high.
Over the weekend, this newspaper had correctly argued that the dramatic declines on May 18 and 19 were not indicative of a reversal of any positive trend. It had quite defensibly argued that "the overall India story is still good". If so, and which it is, we need to determine why stocks crashed and why at 3,200 the S&P CNX Nifty appears to have seen its worst. Price-earning (P/E) multiples provide the path to this determination. The average P/E multiple of the Indian market was about 17.1 on March 1. It was 17.52 at Tuesday's closing.
Abnormal P/E peak
The average P/E multiple of the Indian market was about 17.1 on March 1. It rose steadily to 18 on March 24. It crossed 19 on April 3. It crossed 20 on May 5. It peaked at 20.6 on May 10 when the S&P CNX Nifty closed at 3,754. In 47 trading days, the average P/E multiple had grown by over 20 per cent.
A spectacular rise in the P/E multiple is the result of three forces. The first is earnings growth. The second is the expectation that the systematic risk of the market will decline significantly. The third is that interest rates will remain benignly low. The first force signals higher cash flows to investors. The second and the third lower the rate of discount that is used to determine the present value of future cash flows. Low systematic risk and low interest rates keep the discount rate low. Together they boost the present value of future cash flows. High systematic risk and high interest rates push the discount rate up. Together they suppress the present value of future cash flows.
The market was right with the first force. Most analysts had estimates of decent earnings growth in 2006-07. But the estimates of most analysts showed that systematic risks and interest rates would rise. That is, the market was right in assuming that stock prices will rise as a result of earnings growth. But it overlooked the forces that were exacerbating systematic risk. It ignored the possibility of interest rates going up globally and of shrinking liquidity.
Higher interest rates
It would be pertinent to examine why the market now expects interest rates to rise globally. Most economies that are regarded as steady and regular performers have favourable growth forecasts for them. First, economic data from Europe show acceleration.
The Euro-zone GDP is up 0.6 per cent quarter-on-quarter. Germany, which has hitherto been quiet, is expected to grow handsomely. Second, industrial production in Britain rose strongly and unexpectedly by 0.7 per cent. This is expected to stay strong over the year. Third, US GDP growth estimates will be released on Thursday (May 25). The market expects strong growth in US GDP despite higher commodity prices. Fourth, India and China will continue to grow without losing any steam.
Economic growth needs money. A fight for funds in growing economies typically leads to higher interest rates and lower bond yields.
There is another and a more forcible reason why interest rates will rise. Inventories of commodities have sucked in available funds. These inventories were built at high commodity prices. This has, in turn, pushed the demand for funds. Borrowings have touched credit limits.
Though there has been an easing of commodity prices, there has been no respite for those that hold inventories of the underlying commodities. Moreover, all the major economies continue to be buyers in the commodity markets both to build inventories at slightly lower prices and to feed their vast manufacturing and process economies.
Higher systematic risk
The direction of interest rate changes is no longer ambiguous. Interest rates will rise globally. They will rise in the US, Japan, China, India, Korea and the Euro-zone. But the magnitude of the rise is not a settled detail.
The commodity intensity of these economies is not homogeneous. Their sensitivities to inflation are not the same. Moreover, their target inflation rates are not uniform.
Given that interest rates have an impact on currency prices, it would be pertinent to raise attention to currency management policies. The US, Britain, Brazil, Australia, Japan, China, India, Korea and the Euro-zone are characterised by three different currency management styles. At least one style has a reputation for causing sudden currency price changes.
Reality sinks in
What these mean is that many macroeconomic variables are somewhat in turmoil. The likelihood of each variable's sudden change in value adds up to the totality of the systematic risk. The market in India has woken up to these.
It has quite healthily and purposefully cut prices and pushed down the P/E multiple to about 17. The quickness should cause no surprise since changes in the perception or assessment of systematic risk always have an exponential and non-linear impact on prices.
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