Flush with cash, Sensex continues to climb wall of worry

Buoyed by the newfound resolve of the UPA government and a fresh wave of foreign capital flows, bulls appear to be in command for now. The 30-share Sensex on Friday finished at 18752.83, its highest closing level in over fourteen-and-a-half months, and the 50-share Nifty closed at a sixteen-and-a-half month high of 5691.15.

The market reaction or rather, over-reaction to the reform measures announced by the government must have surprised even the most die-hard of bulls. After all, it will take some time for the FDI policies in retail and aviation to bring in the much-needed foreign capital. And the hike in diesel prices and the cap on the number of cooking gas cylinders is simply not enough to meaningfully reduce the fuel subsidy bill.

But the rally right now is more about liquidity and less about fundamentals. In three trading sessions between September 14-18, foreign institutional investors pumped in Rs 6262 crore into Indian shares. One could argue that fundamentals still don't support a sustained rally. Industrial output has been slowing down, inflation is not yet under control, oil prices continue to rise, and corporate earnings are unlikely to look up any time soon. If these trends persist, the market would be back to square one in a couple of months time.

Yet, in the short term, there is no saying where liquidity could take benchmark indices to. With the central banks in the US and the Eurozone having opened their spigots, there is ample liquidity sloshing about in world markets. And for all the macro problems staring emerging markets in the face, a sudden rush of liquidity can do wonders to stock prices in the short term set off a virtuous cycle even if a short-lived one.

Strategists at a few brokerage houses have raised doubts about the quality of foreign funds flowing into Indian shares, and some have openly mentioned in their reports to clients that a sizeable chunk of the money could be black money re-entering the country disguised as foreign capital. That may or may not be true. But as long as liquidity continues to pour in, fundamentals will have to take a backseat.