“Irrational Exuberance”

Those Words Again

Alan Greenspan is reputed to have used these words in 1995 when the Dow was around 7500.  Robert Shiller made this phrase famous with his seminal book on the ongoing subsequent irrationality.  Mr. Chidambaram recently said (in hushed tones) words to the same effect and at the same Sensex value. 

I mention this because the coincidence struck me.  We see unfolding before us almost the same story here in India.  “History does not repeat itself but it sure rhymes”.

Mr. Alan Greenspan was wrong.  The Irrational Exuberance did not stop at 7500.  Markets rose nearly 60% before falling off the biggest asset bubble in the history of mankind.

5 years and a number of other bubbles later, India seems to be headed the same way.  With bubbles blowing all over the world in Housing, in Commodities and even in precious metals, we are seeing unprecedented international financial flows.  There is media talk about the Japanese rebalancing their Asia portfolio, pulling out from China and pumping unbelievable cash into a much smaller market like India.

The logic being that the Japanese have zero cost of capital and find Indian P-Es low enough to invest.  After all, what are their options?  To buy T-Bills denominated in a heavily depreciating dollar, or to invest in the heavily over valued Euro?

It makes far more sense to invest in the world’s only domestic-led growth story, probably the only part of the world which is not part of the US-China current account deficit imbroglio.   When this structural imbalance unravels, any large investor like the Japanese banks will be left with massive portfolio losses.  India, therefore, is a safe haven – this is the logic of the Japanese flows.

But look at it from India’s point of view.  You have an excess of cash that is flooding in, funding bubbles across all sectors.  This cash will seep into other markets funding bubbles in real estate (e.g. Gurgaon and even Delhi are already running at more than 7 years income and a rental yield of 2%).

So what does poor Mr. Chidambaram do?  His small voice of sanity is hopelessly drowned in the chorus of protest from bullish investors who cannot see this party spoilt.   He is like the arrack-shop owner who knows that you need a bouncer to stop a person after his 12^th peg.  The bullish consensus and the need for liquidity-fuelled overvaluation is now so strong that there are simply too many vested interests involved.  The Mutual Fund industry, the FIIs, promoters of companies who need to make placements, and of course the public-at-large.  There is almost no one who does not have a vested interest in bullishness.

But what is the objective of the regulator?  He is supposed to aid price discovery and is supposed to cool any excessive distortions.  Is anybody in India other than poor Mr. Chidambaram concerned about the long-term damage this excess liquidity will do first to the stock market, and then after the asset bubble collapse, to the economy at large?

Let us go back to Mr. Greenspan.  He said, after the 2000 asset price collapse, that it was only possible for a regulator “to see a bubble after the fact (ie, after it has burst)”.  There have been few comments by central bankers as hilarious as this one.  With this Pontius Pilate-like comment, Mr. Greenspan washed his hands of any responsibility for what happened subsequently to the American economy.  History will not judge him lightly.

No Indian politician can routinely be courageous  (or he will not be a politician for long).  But Mr Chidambaram is at a crossroad.  Is he mustering up the courage to come down hard on almost every participant in the market and soak up liquidity through a sharp hike in interest rates or other stratagems.  Or does he let the party continue?  This may be just the start of a bubble that can take on unimaginable proportions. 

When going into the details, company by company, I can just point to a few examples of the frenzy evident in the markets:

A)   Interest rates, oil prices and auto stocks went up on the same day. 

B)   Companies which have never delivered an ROCE above 11% are today quoted at 25 times forward earnings. 

C)   Temporary spikes in earnings and cash flows are discounted into forward earnings as if they are forever.  In fact a growth rate is imbued into them. This similar to the IT Boom 2000, when valuations were based on extrapolating current growth rates to infinity.

India is not a mature economy, Indians are not mature economic players and our country simply does not have the institutional infrastructure (or even the international standing) to soften an asset-price collapse in the manner that Mr Greenspan has done.  There will be no bonds we can issue which will be picked up by willing foreigners who have a vested interest in the stability of our currency.  The consequences would be closer to East Asia (crisis) than to America.  If this trend is not arrested, I see a 1992-like situation with major bankruptcy spreading out into the retail segment followed by a fracturing of the ongoing housing bubble.

The top of every bull market is marked by scams, small and big. You can see them sprouting all over the place, simply too numerous to recount. They can come from mis-stated earnings, over-hyped news, multiple announcements of old-hat news, co-ordinated trading between institutions and operators….all of these simply impossible to “prove” except by anecdotal evidence. Recently, we saw bears getting squeezed out of a number of fundamentally weak stocks, that should be dropping in value.

This is a rare situation when the regulator needs to take an intelligent, broader view of markets. Just like the RBI intervenes in Forex markets, or like in 1996, when Mr. Manmohan Singh squeezed out excess liquidity to slow down a Capex boom; we need a move to slow down this liquidity-driven rally. 

If left unchecked, the market would move into territory where sentiment becomes a self-fulfilling prophecy. “Stock prices go up because stocks prices are going up”. Such uni-directional sentiment cannot be healthy for the markets, or later the economy.  

If the same phenomenon had been observed on the opposite side, ie, excessive and rampant bearishness, the Govt would have looked for scapegoats. Rather like it went after some brokers, merely because they had short-sold stock at the end of the IT Boom. Somehow, it is virtuous to defend “bullishness”, but it is ok to let bears be killed. This logic is flawed. Contrarians are the anti-bodies who keep the system healthy……..killing them cannot be good for the markets.

The regulator should engineer a slowdown in hot FII inflows, or make them “sticky” (maybe with an “exit tax”). This will keep hot money out, and ensure relatively longer-term investments.