Black someday

We have them so often. Once in a while in different countries the headlines scream "Black Monday". The days when parties rudely come to an end and markets tank. And we are left with a hangover and a nonsensical talk of healthy corrections.

Don't get me wrong . I'm not reading out from pages of financial history. I'm writing about a not so far future, (before the end of year) when we are going to see a 1000 point drop in Sensex almost without a reason. The reasons will be invented later but if look carefully the reasons are being present now. The towering 1.321 trillion dollar market cap of Indian equity market is crumbling under its own weight. The leaning tower of PISA is much more stable. It has withstood centuries. You can years before it falls but the markets?? You better look at figures

The sensex 23.42 times its earning, 5.57 times its book value. The boards of these companies know that these earnings are not sustainable. That is why the dividends yield is at 1.02%. This means only 24% of the earnings is being distributed as dividends.

The E in the P/E ratio is inflated due to

• Clever(but legal) accounting which marks down the interest costs. The indian companies have taken more than 25billion dollars of ECBs/FCCBs. The currency fluctuation gains due to declining rupee are against interest cost. These one time gains are propping up the earnings.
• High prices of all commodities are benefiting primary producers like mines, oil exploration etc. The secondary producers are able to pass up these costs down. For example lets say few years ago I bought X tons of steel at Y crs and sold steel pipes at 1. 2Y crs. Today the same X tons of steel costs me 3Y crs and I sell it at 3.5 Y crs. Even though my business hasn't moved an inch my sales have grown almost 3 times and profit 2.5 times.
• Apart from these special factors there is a genuine growth in economy which is being helped by benign economic atmosphere characterized by low inflation, not so high interest rates, demographic factors and increased productivity.
  

The P/E rations are inflated because

• The markets are confusing the growth in revenues/profits to growth in output. The output of the companies is growing at much slower pace and once the price rise stops, the growth in revenues and profits would be much lower
• The markets are not adjusting for special factors contributing to the earnings
• The markets are extrapolating the growth far to ahead in future when the current global environment doesn't seem to be so conducive for growth.
  

So we are in a situation where the companies are showing better than average earnings and markets are giving these earning better than average discounting in the hope that these earnings are not only sustainable but indicative of even brighter future.

When this optimism comes to an end(I wish I knew when!) a sudden realization would struck the investors that like fools they have been holding risky securities which are paying 4.25% earning yield (out of which you get 1.02% as dividend) when your conservative grandfather is earning a cool 9.5% in FDs riskfree

On the eve of that Black day, the high-flyer portfolio manager will come home and say "You were right dad"