June 15, 2006


Sensex and Economy...

I wanted this to be a two-part post. But, there is a seamless continuation, so I decided to make it a single post. Apologies for the length.

When Sensex started to fall steeply a month back, within days the instant pundits in the media came out with a rhetorical question "Is India story over?" Magazines put this question on the covers with the background of Jeejeebhoy Tower, a thick scarlet-red downward graph, starting on top-left corner and touching the bottom-right of the cover. An editor of a newspaper put the same question in one of the article, but in a slightly different context.

Since Sensex started becoming moving up 3 years back, it has become a perennial fodder for event hungry 24-hour electronic media. On certain occasions, like 17th May 2004, it even managed to become a story bigger than country's premiership. The TV/print reporters pretended to be economist think-tanks, stock analysts, experts on govt policies - all rolled into one. They were wrong then. They are wrong now. For the simple reason that they are looking at the economy through the prism of stock market index.

In my view, Sensex does not fully capture the country's economy. This post makes an attempt to support this argument.

What is Sensex? Sensex captures stock price movement of India's top 30 companies. The companies are chosen based on their financials and free float available. Nifty, another index from NSE, is composed of 50 companies, picked up by slightly different criteria.

The combined market capitalization (referred as m-cap henceforth) of the Sensex companies is around US$ 122 billion as on 14th June. The total m-cap of all the stocks traded on BSE is US$ 500 billion. Approx. 2500 companies stocks are traded on BSE and around 1000 on NSE. (NSE being the newer exchange, did not carry the legacy of earlier mess.) The number of actively traded stocks is still lower. Most of the activity is concentrated in the 150-odd stocks in which derivatives are allowed. That is, 3% of companies command 24% of the m-cap.

This highlights two important things. One, there are hundreds of companies outside Sensex. Secondly, an economy as big as India has thousands of companies, many of which are not participating in the capital market. Look at this - TCS was a private entity till couple of years back. DLF, another multi-billion dollar real-estate giant, is a private company. And so is Hiranandani group. Big players from entertainment industry are not on the bourses.

To give you a sense of numbers, US GDP is around $12 trillion and the combined m-cap of companies listed on NYSE is $17 trillion, majority of which are American corporations . (I could not get same number of Nasdaq, but I suppose even that is equally meaningful with major technology companies listed there.) Compare this to India's GDP of $750 billion and m-cap of $500 billion.

What do "fundamentals" say?

One need not be an equity analysts to check how economy is doing. One can see the signs of activity just by observing few things which one sees everyday. Those giant cranes blocking half of the road, those huge mixers pouring the concrete on other half of the road are screaming about the economy. Spending 150 bucks for latest Yash Chopra flick in spite of negative reviews does indicate the increasing disposable income. The difficulty to find some really good programmers talks about the booming job market. In spite of falling telecom tariffs, the cellphone bill hasn't come down proportionately. That is, we are talking more on phone. Yes, this is all fundamental analysis.

Now we have started hearing about the possible global slowdown. And people are already worried over how badly it will affect India. Here is my take. The slowdown will force companies in developed countries to outsource (manufacturing and services) to lower cost destination (read India.)

Net-net things are not as bad as stock market wants you to believe. Yes, even with some of the mis-adventures like reservations by Govt. things look good.

Where do all these things leave to common investors?

Lets try answer why index is falling. The sentiment in the market is down. It is no longer "FIIs are leaving" story. Definitely not that dubious CBDT cirucular. Due to some steps taken by Japanese banks, the liquidity from global markets is shrinking. So all the hot money that entered in emerging markets and commodities has left. Now, there are very few buyers in this market. The volumes have cash segments have come down by 50%. Volatility has had an adverse impact on derivatives market.

The common investor in India is extremely ill-informed and unsuspecting. Not many will be comfortable to see their capital eroded by 30-50% in a matter of days. Investors have a lesson or two, albeit hard ones, to learn in this volatile markets. First, experts (those coming on TV channels) are not always right. In fact, most of the time they are wrong. Just a month back, people were talking about 5000 level for Nifty. Now the same people are talking about 5000 for Sensex. Every fall meets with "This is bear market," and every rise is greeted by "We are still in bull market." The behaviour of market participants, as quoted often, can be described in two word - greed and fear. And even experts are no exceptions to this behaviour. While we are at experts, the performance of mutual funds has been disappointing. All, and I mean all, of them have fared worse than index. Moral is, don't watch too much of TV.

Another lesson is investing time horizon needs to be years, not months, definitely not days. You don't need to something everyday. Laziness and inertia can be rare virtues in stock market investing. Finally, set the expectations of returns right. Buffet, Lynch, and other Gods of investing have managed to get returns of 25% or so, over a period of few decades. If you think, you can do that, stop kidding yourself and be more imaginative.

On a related note, Franklin India Prima Fund which was closed for fresh investment some time back, is open again. I read it as a signal that market is again ripe for selective investment (as opposed to broad-based).

Hey Shashi, whats a good introductory resource for learing about all this stuff? I mean shares and sensex and stock and derivatives and all that. I don't want a commerce degree, but just want a handle on the basics. By my standards, you seem pretty knowledgeable, so hopefully you can give some useful pointers :-)
One up on Wall Street by Peter Lynch is an excellent starting point. You can also read Intelligent Investor by Benjamin Graham. These books are about investing using fundamental analysis.

The things like Technical Analysis and Derivatives are slightly advanced topics. In fact, Peter Lynch and the likes are against using these methods and instruments. But, for academic purpose, you can go through Wikipedia for a primer on these topics.
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