Markets cannot run ahead of the real economy for long

After months of dismal economic news, we finally have something to cheer. On Tuesday the benchmark BSE Sensex breached 20,000 for the first time in more than a year. And though it finally closed a tad lower at 19,990.08 and Wednesday saw it end lower at 19,818, there is no mistaking the underlying bullish tone. Led by strong, better-than-expected corporate earnings from IT majors Infosys and TCS, hopes of a rate cut by the RBI later in the month, deferment of Gaar (general anti-avoidance rules) and related provisions and most of all, strong portfolio flows, both the stock markets displayed some of the animal spirits that had been missing of late. With investment banks predicting the bull run will continue, chances are the Sensex will touch new highs. While this is undoubtedly good news, any celebration must be tempered with caution. It is important to remember the surging Sensex is part of a global phenomenon. The FTSE All World Index has breached the May 2011 level as the compromise reached on the US fiscal cliff (never mind the impasse on the debt ceiling looming ahead) saw investors pouring more money into stocks during the first few days of January than in the past five years.

Stock market indices are forward-looking. So, a rising Sensex suggests investors' renewed faith in the India story. But in truth the present run-up has some disturbing elements; most importantly, the rise in the share of PNs (participatory notes) in overall FII (foreign institutional investment) flows. PNs disguise the beneficial ownership of shares and often serve as a convenient conduit for suspect money. We ought to discourage them. Instead, the decision to exempt PNs from Gaar is bound to make them even more attractive and increase our vulnerability to fickle flows. Remember, stock markets can run ahead of fundamentals only for a while. If the real economy fails to keep faith with the markets, they will run down as quickly as they have run up. The ball is now in the government's court to see that the real economy does not disappoint. Hopefully, the same reform measures will, over time, reduce our dependence on fickle flows.