Since India's economic liberalisation in 1991, Indian equity markets have witnessed three cycles of boom and bust. The years 1992, 2000 and 2008 will remain seared in the minds of investors. The important question that many investors are currently asking is 'Will 2018 mark another such milestone?'.
Market booms need banking sector complicity
Market booms require money to fuel them. Market up-moves start innocently enough, fuelled by expectations of earnings increase, changes in productivity or deepening consumption markets. They rarely end that way. Hubris takes over and market participants start drinking the Kool-Aid, believing that good times will last forever. Of late, market hubris is being fuelled by a generation of investors who believe that interest rates will remain near zero or negative forever. This has also given way to a belief that valuations don't matter. Unfortunately, this invariably leads to excesses and ultimately manifests in banking excesses.
A brief trip down the memory lane may help put the current market in perspective.
The 1992 bull market was fuelled by an instrument called 'bank receipts' (BRs). BRs were instruments used in a 'ready forward' deal. These deals, meant for temporary matching of liquidity between banks, imply a sale of securities by Bank 1 to Bank 2, with an intention to buy it back at a pre-determined period and price. Since the intention is always to reverse the transaction, the securities don't leave the custody of the selling bank and BR serves as a confirmation of sale and of custody. All that Harshad Mehta, the pied piper of 1992, had to do was to find a bank willing to generate false BRs, for which he found Bank of Karad and Metropolitan Co-operative Bank. These banks generated false BRs which Mehta used to raise money from purchasing banks. He used the money to rig up stock prices, which were then exited at a profit and the money was returned. All worked well till the bubble burst. Once prices fell, the scheme fell apart. There was inadequate money to return to the lenders. The market fell more than 50 per cent from the top before it recovered.
In 2000, the IT index staged a massive outbreak. Almost all companies that had a '.com' domain were expected to take over the world, and all brick-and-mortar businesses were slated to die. India found its market dominated by the 'Pentafour Bull' Ketan Parekh (KP). Employing a strategy of 'pump and dump', Ketan Parekh borrowed large sums from Madhavpura Mercantile Cooperative Bank and Global Trust bank (well beyond permissible limits) to rig up stock prices. His exit was provided by institutions like UTI and other local and global funds, where the fund managers were willing to ignore their fiduciary responsibility for private gains. The burst came with strong targeted selling of stratospherically priced stocks that were being backed by KP - the KP10. Once the market broke, in tandem with global markets, lending banks were forced to declare their complicit behaviour. Again, the markets fell more than 50 per cent from the top before they recovered.
The next boom in 2008 was a function of the US markets. Buoyed by a mistaken belief that real estate prices cannot fall, US based banks created complicated products based on mortgages which were then sold globally as high yield instruments with 'low risk'. Ninja loans - loans to people with no income and no assets - were extended to investors on the basis that an inexorable rise in price of underlying prices will make the loan and interest secure. The flurry of activity led to a global rally of stock prices and then a synchronised global collapse, which took out with it many banks. It required a massive bail-out of the global banking system, leading to an unprecedented fall in interest rates to zero (and even, negative) to reinflate asset prices and let the banking system recover. Since the fall was global and the action synchronised across all banking regulators, the fall was undone quickly (in less than 12 months) but not before the fall from the top to the bottom exceeded 50 per cent.
Lessons from history
A look at the history of boom-busts shows several commonalities:
- There has to be an unsustainable boom - caused by money, usually illicit - being routed to financial assets. Banks are inevitably involved.
- Financial assets need to be meaningfully overvalued.
- Something needs to prick the bubble to return prices to sane levels - usually a discovery of the illegality funnelling money into financial markets.
- The indices fall to less than half their peak value and take a long time to recover. The average time between two peaks is about eight years.
The current market meets several of these criteria - the valuations are well above extreme, over two standard deviations above average. Easy money availability has been the norm globally for a while, leading to companies taking excessive leverage that they are unable to pay back.
In India, banks have lent money without discrimination and now, as it appears, without security (the PNB scam). Tight money situation can now arise as regulators wake up to bolt the doors and tighten lending norms. Investment flows into India can meaningfully slow, both as a consequence of global action (rising interest rates in US and lower tax rates) and local policy boo-boos (implementing capital-gains tax, preventing Indian derivatives from being traded in Singapore). Political uncertainty will rise as India enters into the final lap, leading up to the general elections, with three important state elections to meet along the way.
The only question that we need an answer to is whether we are in a 'real bust', i.e., will the market fall by more than 50 per cent before it recovers?
It's important to remember that India is no longer a local story. It dances to the tune of international markets, with added friction due to policy mistakes we make locally. A true bust will likely require a synchronised fall across global markets - something that is inevitable, but where the timing is difficult to predict. Prudent investors would not wait to check out if markets halve. It makes sense to reduce exposure and wait for the storm to pass over.
Anand Tandon is an independent analyst.