20 February 2000

Irrational Exuberance: Sooner or later, the fundamentals will catch up on you

February 20, 2000

Sunday Times of India

Irrational Exuberance

The share bubble will burst

By Siddharth Varadarajan

When someone getting rich for free openly expresses surprise at the manner of his enrichment, the rest of us should sit up and take notice. As the price of his company's stock crossed the Rs 20,000 mark for the first time last week, N.R. Narayana Murthy of Infosys issued a press release with the following anodyne observation: ``There are no new corporate developments outside of the normal business activities that may impact trading''. In plain English, that means `I don't know why the %$%!@& our share price is rising'. And Infosys is not alone. Wipro has seen its market capitalisation rise by $25 billion in just 20 trading sessions to $40 billion (Rs 1,75,000 crore).

Powered by the bull run in infotech, the Sensex recently crossed the 6,000 level. No analyst has so far been able to offer a credible explanation of what's going on. Three years ago, Alan Greenspan, chairman of the US Federal Reserve, used the phrase `irrational exuberance' to describe the altitudinal excesses of Wall Street. Economists usually use two indicators to determine whether current share prices are overvalued: the price-to-earnings ratio of stocks and the spread between the yield on bonds and shares. If the P/E ratio is too high or if bond yields exceed share yields by a factor of more than three to one, shares are considered overvalued and a downward correction is inevitable. Such a correction has been on the cards for some time now; the only element missing is a proximate trigger.

To be exuberant when the fundamentals of the corporate sector, not to speak of the economy, do not warrant such exuberance, is to be irrational. Sooner or later, the fundamentals will catch up with you. The share bubble will burst. Wall Street may be able to ride out a financial crisis because of the seignorage the US derives from the privileged position of the dollar. Other countries will not be so lucky. In India, those who make serious money from the buying and selling of shares have managed to retail the view that what's good for the Sensex is necessarily good for the economy too. That is why pressure is being put on the government to facilitate the bull run by diverting public savings into the markets. The cut in Provident Fund rates, the tax exemption to mutual funds and the proposal to allow PF monies to be invested in shares are all aimed at enhancing the buoyancy of the stock market, on the assumption that the economy will then grow at a faster rate. But the fact is that the stock market produces nothing and adds nothing to the productive potential of a country. It is no longer the dominant -- or even a significant -- source for corporate fund raising. The stock market is merely an arena where already existing value is redistributed.

Even initial public offerings are less about the infusion of fresh funds than about founding investors cashing in. Higher share prices may fuel what Keynes called `animal spirits' but at least in India and the US, the rising market index has not led to higher levels of capital formation. In India, there is an additional problem: trading on Indian markets is very thin and not particularly well regulated. This means a small number of large players are able to manipulate the market, generating volatility almost at will. This is precisely what is happening right now. The danger is that small investors will be drawn in to the market by the infotech hype and then left high and dry as the manipulators dump their overvalued stock and pull out. This is essentially what happened the last time the bubble burst. So if you are thinking of ripping open your mattress and putting in your life's savings on some sexy sounding IT stock, don't say I didn't warn you.

(Siddharth Varadarajan is Senior Assistant Editor, The Times of India)

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