Vulnerability on the stock market
In the last month, we've seen a sharp drop in the prices of internet stocks, worldwide. These movements have had an impact in India also. For some time now, the extreme rise in prices of internet stocks from 1997 onwards has been a cause of concern. Could a collapse take place? If it did, what would its consequences be, and what could we do in reducing our vulnerability? This episode has also raised larger concerns about the sanity of stock markets, and about the extent to which the Indian stock market is correlated with global markets.
Questions of Valuation. The basic question that is driving all this volatility is the uncertainty about the valuation of "internet stocks". These are firms such as Amazon, or India World, which have no revenues or profits to speak of, but have extremely bright growth prospects. The best experts today lack clarity about the future dividends from these companies. Every day, news breaks, individuals rethink their forecasts, and prices fluctuate in response to these fresh assessements.
Many observers have blamed "the stock market" for being ignorant or naive in its assessement of these stocks. Any sensible notion of valuation would attach very limited importance to the "price to sales" ratio. Any sensible observer walking around one of the umpteen "portals" that have sprung up in India would attach a very modest valuation to them. Yet, I think it's fair to say that the stock market is grappling with an extremely difficult problem, and it is not surprising that the valuations obtained are quite volatile. This uncertainty and volatility is unfortunately also a good cover for market manipulators to exploit.
The "internet stocks" are, of course, very different from the services companies which export IT related services. Most Indian software companies, such as Infosys, fall into this category. It is incorrect to apply valuations which are seen with "internet stocks" to these services companies (it's quite remarkable to see Infosys having a P/E of 600 on NASDAQ). Most Internet stocks earn small revenues, make losses, and have no plan in sight of how they would earn profits. In contrast, Infosys earns large revenues, and extremely attractive profits. It will be hard for Infosys to continue to have EPS growth of 50% per year in the five years to come. The typical Internet stock promises a bright future; the typical software stock can show a bright present.
There is very little in India's stock market capitalisation in terms of "Internet stocks". The websites are still largely with venture capitalists and private equity funds; they have not yet made it into the equity market. Hence, the risk to the Indian stock market from a sharp drop in the prices of "internet stocks" is quite limited.
International correlations. Many observers have bemoaned the extent to which Indian markets are correlated with global markets. There are two parts to this problem:
- The most basic idea is that the GDR and ADR markets close for trading after the Indian market does. News that breaks after 3:30 Indian time (when NSE closes) is impounded in GDR and ADR prices which are visible in the next morning's newspaper. It is hence perfectly normal to see "the NASDAQ price driving the Indian price". Conversely, traders on NASDAQ would wake up and closely look at the Indian price which would guide their trading in the day: they would think that the Indian price drives the NASDAQ price. There is nothing unusual in this per se; it's just a reflection of trading sessions which are exactly out of phase.
- Going beyond the GDR/ADR stocks to the market as a whole, we are seeing a greater correlation between Indian stocks and global markets; we are seeing something of a shift from purely local asset pricing towards global asset pricing. Modern financial economics teaches us that this reduces the cost of capital faced by Indian firms. When shocks to the normal income of an Indian investor are correlated with shocks to Indian stocks, the investor feels relatively unsafe owning these stocks and demands a larger risk premium from them. When the investor sees a lower correlation between his income and the stocks, he is more comfortable owning stocks, and demands a lower risk premium from equities. This is good for India's growth prospect, since it reduces the cost of capital for firms in India.
Vulnerability. There is an unfortunate correlation in our past, between scandals and crises within stock exchanges and movements in stock prices owing to factors in the economy. There are demands that SEBI and the Finance Ministry should "do something" about lower share prices, and in the past there have been unfortunate policy responses aimed at "helping" the stock market through tax breaks or lowered margin requirements. These responses are, of course, entirely inappropriate.
The job of stock exchanges is to function smoothly and reliably, whether stock prices go up or down. We should not face a systemic crisis, and the market should not be manipulated. In the recent past, we saw both: in the form of the manipulation of BPL / Videocon / Sterlite on the BSE in Summer 1998, which led to a payments crisis. Today, we are back to concerns in the shape of market manipulation of some of the prominent IT stocks, a Rs.4000 crore outstanding position between legal and illegal badla, etc.
While the Indian equity market has made enormous progress in the decade of the 1990s -- with the introduction of electronic trading, novation at the clearing corporation, and settlement at the depository -- there are important vulnerabilities that have yet to be addressed. We suffer from leveraged trading on the spot market through the use of futures--style settlement and badla, with all its risks in terms of market manipulation and systemic risk. We have not yet made a serious start on the migration into rolling settlement (apart from cosmetic announcements about irrelevant stocks). We have not even contemplated the elimination of leveraged trading on the equity spot market: the existing policy position at SEBI envisages the perpetuation of badla and stock--futures trading under rolling settlement, a path which largely eliminates the gains from rolling settlement. We have not yet commenced on trading in futures and options trading on the equity index.
These issues are not new. India could have moved on with rolling settlement, the abandonment of badla, and exchange-traded derivatives, in 1996; instead we are making no progress with the same questions four years later. These actions would have given us a less vulnerable stock market today. If the stock market volatility of the next few days gets policy-makers to rethink their support for a flawed market design on the equity spot market, it will be a valuable contribution.
Back up to Ajay Shah's BS column