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The Indian capital markets we are in, was driven in large parts by an excess of liquidity globally. The underlying growth story is intact but the valuations are not, because they were not right to begin with.

So where did it start? In the aftermath of the 2000 burst - the most severe recession in recent history. The FED, BoJ, ECB, and BoE cut rates to their lowest in history. Japan cut its rate to close to zero, where they were literally giving money away. These central banks represent the largest store of capital and when they eased monetary policy simultaneously, money become available to all that wanted it.

The first signs of off take began in US real estate with a spate of refinancing of mortgages at lower interest rates. This increased the disposable income with consumers who did what they always do - consume. This consumption created huge demand for goods. And here we found our next price leaders - emerging markets, especially China. China stepped up to meet the increased demand for cheap goods. Its economy began to zoom to 11% growth (13% by some unofficial counts). The Chinese supply machine in turn needed unprecedented levels of raw materials. Thus began the run on commodities - oil and basic metals in particular.

The cut in interest rates globally meant more people could afford housing. Real estate booms tend to be self feeding, as people buying starter homes buy it from people who are moving to bigger places and they in turn are buying from the people upgrading still and so on. This is the Plankton Effect. Once the real estate boom was set in motion it spread to Europe and China. Ireland which is still largely agrarian became one of the most expensive markets. But the Plankton Effect runs out when people with the ability and willingness have all got their houses. This is where natural macro economics ended and human frailty took over. To keep the real estate engine going (influences 70% of US GDP directly or indirectly) banks provided sub-price and no down payment loans to attract more people to join, i.e. to feed the engine.

On the heels of the real estate growth, private equity firms began to fuel a boom of their own. The economics of both real estate and private equity tends to be very similar. Both leverage upwards of 80% to fund their purchases and they both feed off of low interest rates. This corporate buying frenzy brought the play squarely to the capital markets where valuations quickly began to separate from fundamentals. This happens because low interest rates along with high demand lower the equity risk premium which in turn increases valuations (Greenspan’s favorite punching bag). Banks (yes the same guys now going out of business) fell over each other to lend at ever aggressive leverage terms, channeling hundreds of billions of Dollars to the private equity excess. Taking a cue from PE, hedge funds stepped in to borrow money for cheap in Japan and invest in commodities and capital markets around the world (heard of the Yen Carry trade?).

The dry powder in place, all it then needed was a spark- a good believable story. Enter BRIC - a realistic story with rationally defendable fundamentals and growth to boot. What followed was a predictable expansion of multiples across the board in these countries. There wasn’t a stock we didn’t like. This in turn fed the internal demand which made exaggerated valuations seem justified. Then two most dangerous words in finance - strategic purchase (read unjustifiable on demonstrable reason alone) and Governments (insert your own adjective) came together in sovereign funds. The reserves rich Chinese went shopping for commodities especially oil. China aggressively sought oil assets in Africa, Canada, Iran and South America at very high valuations. Oil went form $30 a barrel to $60 and then to $100. The huge petro dollar reserves with OPEC countries also began to look for a home and since US, the traditional store of global excess capital, post 9/11 wasn’t welcoming of some OPEC money, the capital flowed eastwards.

Then we found the last fool and the party fizzled. But how? What about fundamentals and changed economic order? It ended where it began - US Real Estate. The Fed went after the bubble in the US by raising rates to over 5%. The cycle began again in reverse exposing imprudent lending practices first in real estate and then in private equity. Contraction in liquidity and it attendant losses state-side meant people had to liquidate their profitable positions internationally to shore up their balance sheets. Decoupled indeed!

What we are seeing in Indian capital markets is an expected contraction in multiples purely as a consequence of lower global liquidity. So, now begins the search for the bottom which is essentially a study in liquidity. The OECD has already moderated. Reserve rich China and the Oil Complex remain. China is precariously perched. Its external demand led economy is strained by the recession in US and most likely Europe. The Shanghai Index has already dropped by 45%, about as much at the NASDAQ post 2000. China’s real estate markets are already showing signs of overheating and chances are its likely to get worse before they actually owns up to it. Don’t expect too many admissions by the Chinese till the Olympics are over. The leading indicator therefore to watch is oil. The demand side has given way but sovereign funds are buying to shore up inventory. When oil shows sign of contraction that is when we will head towards a consolidating bottom. Watch for oil to go to $70 in a heart beat and then moderate around $55-65, could have gone lower but for the weakness in the Dollar.

The take away for the Indian capital markets is positive. Liquidity being at reasonable levels, valuations are beginning to look realistic. The growth of the Indian economy is levered to its demographics, it is the only major young country (50% people below the age of 25), all other developed countries and China are aging. The Plankton Effect that we saw earlier will move in India’s favor. So, all that you have heard about the India story is correct with two cautions. It is a 15-20 year journey and we will take lumps (current contagion included) along the way.

A 14,500-15,500 Sensex will provide great buying opportunities into companies that would define the next 50 years. Why these levels, markets are systemic processes so it will over do the pessimism just as it did the optimism. The next 6 months would be the best time in a generation to pick stocks for your retirement. Welcome to a stock picker’s market. Wiser for the ware and happy hunting!

Raj Majumder (raj.majumder@imetanoia.com) The founder of iMetanoia is from The Chicago School. iMetanoia.com is a financial services firm focused on the individual investor.