What if We Run Out of Fools?

Apr 28th, 2006 | By Penny Sleuth Contributor | Category: Investing Strategies, Macroeconomics

Some of you wrote to me asking about the Indian stock market. I am following the market very closely and here is what I told my subscribers of the Agora Financial Special Report Series yesterday. Here are some thoughts…

Indian venture capitalist Anand Sridharan thinks the Indian stock market is overheated. He says, “Every report that I read in January ’06 showed year-end estimates for the Sensex at 11,000. The authors of these reports don’t seem overly worried that we’ve reached the 12-month target in three months.” Anand recently raised an interesting question. I’ll come to that in just a second.

According to Anand, this is a classic “greater fool” situation. Investing in an overheated market is foolish. All investors are hoping for is that there are greater fools out there that will buy the same overpriced stocks that they sell.

“What if we run out of fools?” Anand asks.

I don’t know if we’ll ever run out of fools. But I do know when an attractive stock market is turning into a fool’s game. And India’s stock market is certainly itching for a correction.

You may recall that I mentioned India’s last disastrous correction in a previous Sleuth article. Bear with me while I explain it once again; there is an important outcome here…

Rewind to May 17, 2004. After elections, the incumbent BJP party of India was defeated and the Congress party and a communist coalition was elected to power. Widespread panic followed. Investors were intensely paranoid after the election results. As a result, they all rushed for the exits. Indian stocks were punished like never before.

In just 25 minutes, the BSE Sensex lost 15%, the largest one-day decline in its 100-plus-year history. In fact, the panic and sell-off was so bad that regulators stopped all trading and shut down the stock exchange.

Sounds like a nightmare doesn’t it? But the events of May 17, 2004, provided opportunistic investors with the BEST entry point ever. If you had invested $1,000 in the BSE Sensex index amid the panic of May 17, 2004, you would have $2,585.21 today (assuming you got no dividends).

Let’s say you waited for the May 2004 correction to reverse — the BSE Sensex went back to its pre-selloff level in November 2004. $1,000 invested in mid-November 2004 would be $1,949.66.

So if you invested $1,000 during the correction, you would have $2,585.21 today. If you invested after the correction, you would have only $1,949.66. That means you made 32.6% more profits just by investing during the correction!

If you want to invest in India, that’s what you need to do — wait for a correction and then jump in. Indian stocks as a group have a P/E ratio of about 20, making India the most expensive market in Asia (outside Japan) and more expensive than even the Dow. At this time last year, the multiple was just 13. I don’t think these lofty valuations are sustainable.

Now, don’t get me wrong, I am still bullish on India’s long-term performance. That’s why I wrote a whole report on it for my subscribers (we then sold the stocks in the report last month for a double-digit profit).

But as investment bank Morgan Stanley put it, “Indian stock market activity may have to undergo a vicious correction or a protracted phase of low growth to allow the real economy to catch up.”

I doubt the correction will be “vicious,” but the stock market definitely needs to take a breather. The New York Times points out some signs of over-optimism:

So buoyant is the sentiment that an initial public offering by Reliance Petroleum — the largest public offering in India so far this year — sold out in minutes last week
Last year, investors bid for 175 times the shares’ worth in the public offering of FCS Software Solutions of New Delhi and 76 times the worth of shares offered by Sasken Communication Technologies of Bangalore.

As the Times says, “Analysts and fund managers are cautioning that the stock market pendulum may have swung too far, and they warn that some companies are highly overvalued.”

So if you are an India bull, here is my advice to you: Wait for the market forces to skim off some of the froth.

Regards,

Sala Kannan
April 28, 2006

Penny Sleuth Contributor

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