The Great Indian Market Crash of 2006

The BSE is trading at more than 21 times its Price to Earning ratio. In simple terms, it will take an investor more than 21 years to recover the cost of his investment, not taking growth into account. This is obviously very simplistic argument, but you get the drift. To give you a perspective, the Dow Jones Industrial Average (DJIA) is trading around 22 times.

Yes, Indian stock market is now at the same price point as the US. This, despite the fact that there is about 250-550 basis point country risk premium attached to the Indian stock discount rate. This is nothing short of hyper-irrational exuberance. These kind of valuations are not justified even on a growth adjusted basis. Even considering a generous 11% growth rate for non agriculatural sectors, this translates into a PEG of 1.91. This compares unfavorably with the PEG of DJIA, which stands at 1.6.

A brief, and informal, survey done by yours truly of ordinary Indian seems to suggest that most of them have stopped pumping-in more money into stocks for now. There is a general feeling that the market is overvalued.

Then why is the market not correcting? The answer seems to be the FIIs. More than 20% of the money invested in the market is by these institutions. Why are they still in the market if it is overvalued? The answer is twofold: i) Lack of alternatives; and ii) Fear of market impact.

i) Over the last few years, hundreds of Indians have taken advantage of the buzz surrounding India and gained a foothold in the foreign financial markets as India experts. These guys are now caught in the spin cycle that they created. For them to pull out of the Indian market means losing their sway in their firms. If Indian market goes down, they go down with it. This escalation of committment is like playing the Russian Roullette - You keep pressing the trigger and if the market goes up, you win. But eventually, they will have to come to the loaded chamber...just a matter of time.

ii) Some of the saner money managers are stuck in the market for another reason. There is no one to buy from them. And if they unload their holdings, the market will not be able support the supply and they will drive down the prices.

Either way, the result is not pretty. So what do they do? One word - PROPAGANDA. They organize investor conferences, bring out pie-charts and spreadsheets and convince each other that the market is solid. They do all this in air-conditioned hotels and sanitized campuses of major companies. What they try to forget about is the woefully lagging infrastructure - shortfall in energy, crumbling roads, slow judicial process.

In short, they are loading-up the table with heavy goods, but not reinforcing the weak legs of the table. Eventually, the table has to fall under its own weight.

So what is going to happen? A rudimentary analysis seems to indicate that we are looking at about a 25-50% correction. This range was calculated by rationalizing the P/E as well as the PEG ratios.

For a healthy and growing developing country, P/E in the range of about 16 is what one would expect. This P/E is 25% less than the the P/E of 21 that we are seeing in the market. This is how I got the lower range of the correction.

PEG of BSE is close to 2 right now. An ideal PEG is around 1. This supplies the upper range of our correction, which is 50%.

The current optimistic estimates of Indian market capitalization place it around $900 billion. So, based on my analysis, it would seem that the market stands to lose between $225-$450 billion over the short term.