When Dot went dotty on Dalal Street

Suddenly, last week, Indian tech stocks mimicked Nasdaq\’s mood swings and crashed to a near-meltdown, setting investors on the run, before settling back on their perch. What caused this economic bungee-jump? Was it a sign of bubble-bursting that the nebulous Internet stocks were doomed to face or a routine fluctuation of fortunes? The Sunday Times unravels the secrets of this new-fangled economics that makes up the high-tech market psychology.

When Nasdaq sneezes, the world catches a cold. It is an alarming example of globalisation gone wrong. The crash in India\’s stock markets last week mirrored the crash on Nasdaq, the US stock exchange specialising in technology stocks. Now, all markets go up and down. But never in history has so much money poured into stock markets the world over, and never before have stock markets the world over imitated the gyrations of Nasdaq. That is a cause for worry.

Indian companies wanting to be quoted in the US invariably choose Nasdaq rather than the venerable New York Stock Exchange, which once dominated the US market. The US has moved into a new knowledge era, in which manufacturing is regarded as a sunset industry and knowledge-based services are seen as the wave of the future. This has had its echo in India, and produced fantastic increases in the price of infotech, media and comunications stocks. Some call it a new ICE (Infotech, communications and entertainment) age.

Last year, the share price of Wipro rose from a low of Rs 616 to a high of 9,800 before receding partially to 5,000 in last week\’s crash. Zee Telefilms has fluctuated from a low of Rs 81 to a high of Rs 1,630 before settling at around Rs 1,000 last week. Mirroring Nasdaq, Indian stocks are still big net gainers over the last year. And ICE stocks now account for 40 per cent of the market capitalisation of the Bombay Sensex.

Mad gyrations are common enough in Indian stock markets. What is new about the bull run in the last year, as well as the crash last week, is that the Indian market is mindlessly imitating Nasdaq. This is not happening simply because foreign institutional investors are in both markets. It is happening because Indian investors have decided that the easiest way of making money is imitation. So have investors in Hong Kong, Singapore, Tokyo and elsewhere.

This leads to self-fufilling expectations. The more investors believe theSensex will mimic Nasdaq, the more they will buy and sell in line with Nasdaq, and that by itself will ensure that prices actually rise and fall with Nasdaq.

If enough people jump on this bandwagon, life becomes very risky for contrarians. It is safer to run with the herd than go in the opposite direction.

Now, this is the very opposite of the behaviour a well-functioning market should exhibit. In a developed market, information should be so deeply and widely distributed to investors that surprises should be rare, and share prices should generally reflect fundamental strengths and weaknesses of companies. Contrarians abound in a well-developed market: as soon as the price of a stock falls, contrarians see it as an opportunity and rush in to buy. A well-developed market is like a milling crowd, with people moving in all directions but relative stability for the crowd as a whole.

The opposite is true of underdeveloped markets with little information, depth or liquidity. In the absence of reliable, well-distributed information, rumours and fashions produce wild swings in prices. While developed markets look like milling crowds, underdeveloped markets look like stampeding herds, with all investors running together one way or another. In uncertain times, herd behaviour is not irrational: it is a rational way of avoiding getting stranded.

The globalisation of stock markets should have produced deeper, solider, better informed markets than ever. This has not happened. On the contrary, the herd instinct is triumphing everywhere, even in Nasdaq. Why? Because housewives, students and blue collar workers in millions have started investing in the US stock market. They open internet trading accounts with brokers, which allow them to trade on their own account on borrowed money. US brokers automatically allow borrowing up to 50 per cent of the current market value of your shares, and you can invest that in ever more shares in a rising pyramid.

This massive eruption of amateur traders has upset all traditional market norms. Legendary global investors like Warren Buffet and Julian Robertson have lost huge sums in the ICE age. The price of these shares bears no relationship to fundamentals or past performance. It is determined by optimistic projections of future earnings. Companies which have never made a profit, like Amazon.com, are quoted at stratospheric prices. Indeed, when a company starts making a profit, its price can fall, as investors decide that it is now getting mature and so has limited growth prospects! Since there are no yardsticks for measuring future growth prospects, decisions to buy or sell are decided by the mood of the moment, not by fundamentals. When optimism rises, so do stocks. When pessimism sets is, stocks collapse.

This herd behaviour has been given a sanitised name: momentum trading. You buy or sell depending on the momentum of the market. The momentum has been upwards for years; the Nasdaq Composite Index has gone from 1,000 to 5,000 in the last five years before settling last week at 4,400. All the amateur day-traders joining the ride have become wealthy.

But last week\’s crash was a reminder that momentum can be down as well as up. I personally believe Nasdaq prices are highly inflated, and will come down sharply one day. The current fashion of investing in companies that have never made a profit cannot last. When Nasdaq crashes, that will send a tidal wave through imitative stock markets the world over. It will be a wave the like of which has never been seen. So keep your life-jackets handy.

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