Financial Times

Booming stocks and market risk
Colombo's stock market had long been dominated by foreign investors. A perennial complaint of foreign investors and market regulators trying to promote stock market investing has been the lack of depth in the Colombo bourse owing to insufficient investments by local investors.

The lack of market depth was seen as one of the main reasons for the difficulty in attracting more foreign funds into the market because this limited trading opportunities and opportunities for a quick exit from the market.

Now it seems that the roles have been reversed and locals are in the driving seat with foreigners taking a back seat. Foreigners, especially the foreign funds whose money the stock market has been eagerly trying to attract, have largely kept their distance in this latest bull-run. As some brokers have acknowledged some of the local investors who have been driving the market to new highs may be risking their money out of ignorance. They are merely following the herd mentality and might be putting money in stocks that may not be worth the prices they are paying now.

These are the so-called 'penny stocks' that seems to be the latest plaything of investors. Even in the hotels sector, brokers have warned that not every hotel will do well and that some are heavily indebted and may not make profits.

A good yardstick with which to measure the validity of a bull run is to watch the behaviour of foreign investors who are usually better informed than local retail players and are more discerning. Foreigners are also known to be more savvy when it comes to trading and have been known for buying during downturns and selling when the market hits a peak.

Another factor driving stock prices is excess liquidity. Investors have limited options in the present situation. They can invest in money market instruments like treasury bills. But with inflation on the rise these may not yield attractive returns in real terms. However they can be assured of higher returns if they risk their money in the booming stock market - although the risks may be higher as well.

Critics of the government were fond of pointing to the market crash soon after the UPFA won the elections as a sign that investors lacked confidence in the government and that this could spell doom to the country.

The same thing happened in India after the Congress party's surprise election victory. There the media was blamed for focussing on plummeting stock prices and the gloomy forecasts of stock market players and ignoring the opinion of the wider population expressed so clearly at the polls.

If we take the same yardstick as used by the government's critics to measure the performance of the Colombo bourse then it would seem that the current boom in the stock market is a sign of confidence in the government!

To be sure, many firms have been reporting handsome profits. But, as some brokers have warned, they might not be able to sustain their profitability in the coming months as economic conditions get tougher.

The inexorable rise in inflation is a sign of things to come. A wave of cost increases will surely hit the corporate bottom line. Only a few firms, monopolistic in nature, will be able to pass on the full impact of these cost increases to consumers. Others will have to absorb at least some of these costs which will erode company profits.

Then their share prices will fall. If and when the crash comes, it is the locals who, in their enthusiasm or what might be called their "irrational exuberance", have driven the market to its new highs, will lose money.

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