A Red Flag for India's Bull Market

Will India's bears come out of hibernation this spring to put an end to the bull market? Stocks are trading high, but earnings may be down

Forget the sacred cows, here come the bulls. Investors in India seem to be having a fit of exuberance, irrational or otherwise. Bombay's benchmark stock index, the Sensex, has broken records almost every day this year, moving from 9,390 on Jan. 2 to 11,747 on Apr. 5. At least $11 billion in foreign money has poured in over the past year seeking to capture the 50%-plus gains seen in 2005.

And big-ticket initial public offerings by the likes of Reliance Petroleum and low-cost airline Deccan Aviation are likely to pump up the excitement even further, attracting as much as $22 billion in new cash to the market this year. "India has moved from being a small car to a Ferrari," says Andrew Holland, Merrill Lynch's (MER) head of research in India.

By many measures, it appears the bulls may be onto something. They point to the likes of Infosys (INFY) and Tata, which are among the best-managed companies in the emerging markets. The country's youthful, increasingly educated population is eager for work. Successive governments from opposite ends of the political spectrum have persistently backed economic reform. And local investors are starting to join the party, as Indian mutual funds raised nearly $4 billion in the first quarter, compared with $242 million for the previous year period.


  Some, though, wonder whether the bulls are being led to the slaughter. The 30 companies in the Sensex, or the Sensitive Index, are trading at an average of 20 times their expected 2006 earnings -- one of the highest multiples ever and even higher than the average of about 15 for the Standard & Poor's 500 index. Meanwhile, corporate profits are estimated to have climbed 15% in the fiscal year ended Mar. 31 -- well ahead of the Asian average of 6%.

Those IPOs in the pipeline should mop up much of the excess cash sloshing around, which could cut into demand for existing issues. "Right now, there's too much money chasing too few stocks," says Prithvi Haldea, director of researcher Prime Database, which follows the IPO market.

Then there's the problem of the foreigners. Overseas investments account for three-quarters of new funds flowing into the market. If the tide turns, they could quickly vanish. "Foreign institutional investors are supporting India's growth," says Ridham Desai, co-chief executive of JM Morgan Stanley in Bombay. "If they twitch, India will dip. The market is disregarding this."


  Interest-rate hikes could also hurt. India's central bank raised short-term rates to 6.5% in January, their highest level since 2003, while U.S. rates are at a five-year high. "In an environment of rising rates, equity markets aren't the only alternative," says Mark Syn, executive director of Goldman Sachs Asset Management (GS).

The first indication of a market slowdown could come this month, when results for the last fiscal year are made public. Earnings grew 15% in the quarter ended Dec. 31 -- half the 30% growth of the past three years. Analysts expect growth of 18% to 20% now, but with valuations as high as they are, there's little room for companies to make mistakes. "God help the market if earnings are lower than 15%," says Dinshaw Irani of Bombay investment advisory firm Artemis Advisors.

Still, such an outcome seems inevitable. Stars of previous quarters such as Tata Steel and petrochemicals giant Reliance are subject to commodity cycles and will surely see slower growth. Indian companies are investing in new capacity, but face an acute shortage of management talent to execute their plans. "India is a good 10-year play, but in the short term there are risks," says Madhav Bhatkully of Bombay's New Horizon Investments.


  Try telling this to investors, and "they roll their eyes and say it'll work out in the long run," says Manish Chokhani, director at Bombay brokerage Enam Securities. This year, Morgan Stanley reckons foreigners will invest $20 billion in India's stock market, nearly double last year's figure.

And at annual Indian investment conferences of Deutsche Bank (DB), Citigroup (C), Merrill Lynch, and Morgan Stanley (MS) in March, attendance was far higher than last year's levels. Sure, India has plenty of long-term potential. But this spring, it may be time for the bears to start pushing the cows -- and the bulls -- out of the way.

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