How long is this going to take?

It must come as some surprise to many, as it has to us, to see the stock market rally the way it has in the first four months of the year. It's been nothing short of spectacular. And while this gives common investors much to cheer, it causes equal consternation to those who continue to hold on to their stocks and to those who have investible surpluses.

In question is the sustainability of the trend, the depth and duration of the next correction and coping with the risk of being almost entirely at the behest of external global factors. These are some of the fears that investors are grappling with even as the Sensex continues to plow ahead.

On the other hand, the factors propelling today's rally remain in place. There are indeed many and it is not just liquidity as is commonly believed. Liquidity is in fact, driven by the belief that India – fait accompli – will become an economic power in the next ten years or so. But wait there is more reason why foreigners are so hot on India.

Since the start of the year, the incumbent government has finally come out of its slumber and has talked about several measures to sustain growth and address infrastructure problems, open up sectors such as retail, coal, power, civil aviation and defense procurement. The continuing power cuts and shutdowns have led to the government having been seized with a sense of urgency to get its act going.

The prime minister in particular is visibly seen pushing India's case at foreign trade fairs and diplomatic enclaves. India has been less equivocal of foreign policy issues like Iran and the US, which indicates that it is aware of its increasing economic strength rather than military might.

It is crucial now that the government walks the talk. The third and crucial leg, and which is more germane to the market itself, is that corporates have delivered on promises thus far and that has kept analysts busy either holding or raising earnings estimates for FY07 and FY08.

Now if some of these were to turn sour or fall short of their heightened expectations (they need to justify higher valuations to peddle stocks for their brokerages!) such stocks and well neigh the market risks sharp de-rating in the medium term.

Inspite of interest rates rising in the US to close to 5 per cent now, the US GDP growth has been strong enough to mitigate the ill effects of higher cost of money. Obviously the global imbalance in trade between the two largest trading blocs – the US and China – remains a huge concern. On the other hand high crude price-driven riches from the Gulf region and an economic recovery of sorts from Japan ensure that global liquidity flowing into asset classes ranging from equities to commodities to hard assets continues unabated.

Like all good things, this unprecedented boom running across global asset classes too must come to a halt even if it is temporary and lasts between a few months to a few years. Inspite of reams of reports churned out by analysts, economists and the sort, none with any degree of certainty can pin down the inflection point of this manic global boom. For that matter neither does this columnist pretend to do that.

It simply means that a majority of investors across the globe will most likely be 'reacting' to such changes with anxiety and helplessness, than be responding 'pro-actively' ahead of the inevitability. We know of some brave souls who have and would rather take their winnings now and retreat to the ski slopes of Chamonix or take a holiday in the French Riviera in these times.

The rally in the Sensex has so far been driven by the twin legs of continuing foreign love-risk for Indian equities and resurgent optimism from domestic investors seeking better returns and willing to take heightened risk. In the last two months we've seen wavering FII inflows (although they are yet positive) leading to sharp volatile swings in the market. Domestic funds have been simply doing what the masses have mandated them to do – gone forth and bought equities, risk be damned. Can't blame them too, can you?

We've reached a juncture where the market capitalisation of India is equal to or exceeded the nominal GDP. Or that bond yields on the benchmark G-Sec yield more than the earnings yield of the Sensex. Or that the dividend yield of the Sensex is at multi-year record lows. There could be more statistical matrices that will tell you that we are closer to the top than a bottom. There will be even more generic and anecdotal evidences that will suggest the same. And yet not many will heed these warnings today.

Its because we are in that phase of the bull rally where greed for a few bucks more and the fear of being left out of the game weigh heavily on the psyche of the common and sophisticated investor equally. Its that gut-wrenching unseemly geomagnetic pull that draws us into the vortex of the very dangerous game that's now at play 9.55 am to 3.30 pm each day on the flickering ODIN and Bloomberg screens.

With such potent forces at work is it any surprise that valuations, the bedrock of all economic asset valuations have almost become a bad word? Valuation has been replaced masochistically by terms such as news flows, earnings momentum and new matrices to justify which stocks trade at current prices.

The flow of IPOs has turned into a veritable torrent and quite a handful of mega and large IPOs mainly from the real estate space are lined up for the near future. These will place some pressure on the secondary markets surely for funds unless liquidity and equity appetite remain boundless. At best they will help in dampening the flush of funds in the market. At worse they could well be a contributing factor in slowing down the inexorable rise of the market.

After a long lull several mid and small cap stocks are showing signs of recovery. Their recovery has so far been sporadic and selective so that the group as a whole has not rallied and hence escaped the notice of the media's glare and gone unreported. Is this a consequence of the March results effect or is it a genuine shift in capital at the margin back into this space will be known only if their present rallies bloom into full blown ones through May. Else most of these rallies might end up being termed as mere pullbacks, and the downtrend in them will re-emerge.

Banks – the final frontier
One sector that has been left untouched largely by the market and where we see significant shift in perception and valuations is banks. Considering that a large part of the market comprises government-owned banks where the ownership limit for foreigners is 20 per cent, this has perhaps been the biggest bane in their valuations remaining moribund.

There have been other factors in 2005-06 mainly the big inflection in the direction of interest rates. Hence banks have under performed big time and the valuation differential between the benchmark indices and the banking sector has indeed widened even though the earnings of banks despite a tough year has come through largely unscathed.

Now that banks have aligned (the remaining will in 2006-07) their treasuries to a large extent, most of the weakly capitalised ones raised fresh capital and their book values shored up, banks on an earnings and asset value basis look like the last frontier left unconquered by the market. Banks being central to economic growth and seen in the backdrop of the hot growth of 30 per cent in credit in 2006, we would be really surprised if bank stocks didn't fire on all cylinders now.

This bull market has flirted with danger several times. It could well take an innocuous arrow among several to strike it on its Achilles' heel. The zillion-dollar question is nobody knows yet what that is insofar as the market is concerned. So like Achilles the warrior, savour its strength while it lasts.

*The author is head PMS and Investment Advisory, IL&FS Investsmart Limited