Friday, March 31, 2006

Sensex or NonSensex? Part I: Is the Indian Stockmarket Overvalued

Since in earlier postings we have been very bullish or atleast very enthusiastic about becoming Crorepatis or even Billionaires, we would like to balance that a little with the idea of risks. Any potential wealth-building process would face certain risks. We are talking about very high returns (~15 to 35%), these are available mostly through investing in the equity market. We have suggested that a passive and easy way for one to do that would be through a well-chosen equity mutual fund. You do the choosing once and then let the fund manager sweat it out.

Another way is, of course, to do it yourself by directly investing in the appropriate equities or company shares in the stock market. That requires lot of time, efforts, skill-building and monitoring on your part.

In either path of investing in the equity market, you would encounter market and security risks. We would like you to understand how risky the current Indian stock market looks. Please don't jump in where angels dare not tread.

The Sensex is an index to signify the overall position of the stock market on the Bombay Stock Exchange. Right now it is at an all-time high of 11000+. Are these market valuations justified?

Lets consider a few indicators to see if we can judge the relative riskiness of the market. The GDP of the Indian economy is somewhere about Rs. 27 Lakh Crores. The current market valuation is somewhere about Rs. 35 Lakh Crores or much more. (I am not vouching for the preciseness of the numbers here. But if you see a fat man you can know he is fat. A couple of pounds here or there will not make him less fat. ) This means that the Market Valuation to GDP ratio is >100%.

Now Market Valuation/GDP ratio is a macro-level ratio that is analogical to Price/Sales ratio. Typically, when Price/Sales <> 1 the attractiveness of the stock becomes suspect. Most likely all the future value it is going to create has been factores into its prices. Certain high-growth stocks do command Price/Sales ratios >1. However, a Prices/Sales ratio > 1 for the aggregate market is very difficult to be sustained. It is a clear case of overvaluation.

Earlier crashes in the US stock markets have happened at Market Valuation/GDP ratios of 83% for the 1929 crash, 80% for the 1968 crash, 71% for the 1987 crash and of course the mother-of-all bull runs the 1999 peak was at 190%! Of course, the 1987 to 2000 was one of the longest over-valued bull run ever seen. There have been several bulls runs across world markets and many of them have been fair-valued bull runs. But this one was definitely an overvalued bull run but it went on and on for nearly 13 years!

So definitely, we are in the overvalued regime as far as the Indian market is concerned. Consider added issues like, agriculture and not industry accounts for a greater portion (~50%) of the Indian GDP. So that part of the GDP is not mirrored in the markets. In that sense we might be very close to 200% of the Industrial+service contribution to GDP that is reflected in the Sensex.

We will continue these investigations with other indicators that can throw light on the overvaluation issue.


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