The excitement these days on the bourses is whether the BSE Sensex will breach the 7,000 levels in this week! While the sense of optimism about the returns from the stock market is apparent, probably, it is time to be rationale.

Yes, the benchmark BSE Sensex is at its new highs and prospects from a long-term perspective are promising. Does it mean that one should buy stocks lock stock and barrel now?

Here are some of the 'caveats' for investors (and not punters).

1. Why is there anxiety about the 7,000 'magic level'? The Sensex is just 102 points away from touching the 7,000 mark, which is just 1.5% from the current level. Even if the Sensex touches/breaches this 'magic level', it is not that stocks all of a sudden become even more attractive.

   At the current level, on a trailing twelve months earnings basis, the Sensex is trading at 17 times. Assuming a 15% growth in net profit of Sensex companies, the forward multiple works out to 14.8 times, which is not really inexpensive.
   

2. Second is about the 'India story.' Barring concerns regarding interest rates and government finances in the next one year, the long-term fundamentals of the Indian economy are strong enough to believe that India will attract more foreign interest (FDI, more importantly).

   But, at the same time, "India is trading at a 40% premium in terms of valuations as compared to other emerging markets," as Ajit Dayal, CEO & CIO, Quantum Advisors, says. Who said Indian equities are cheap?
   

3. Third is about the hard sell with respect to the 'attractive valuations' itself. As we had written in our stock market strategy note at the start of the calendar year 2005, there are two parts to valuations of stocks.

   One is the fundamentals itself i.e. the long-term earnings capability of corporates, demand-supply situations and so on.

   And second, 'expectations' i.e. what investors (individuals, institutions, FIIs and whoever else) are willing to pay for the fundamentals? Some investor may be willing to buy stocks at 15 times price to earnings multiple and some may be comfortable buying at 12 times multiple. This is governed by the risk profile of investors.

When the market is bullish, as it is now, there is a tendency to overshoot on both the sides. It starts with corporates posting good results, which then is reflected in the stock price.

Once the stock price starts rising, 'expectations' of growth and valuations goes up. This, in turn, pushes the stock price to new highs. Once the stock market understands that 'corporates resources' are limited and growth is not infinite, stock price will again come back to trail fundamentals i.e. EPS growth and sustainability.

Again, we are not trying to be doomsayers here. We do recommend stocks to our subscribers even at the current level. But we are only trying to place the 'other side' of the story so that investors pay attention to the downside risk before looking at the upside, which can be, at times, misleading!

This is part of Equitymaster's Budget 2005-06 series. Equitymaster.com is one of India's premier finance portals. The Web site offers a user-friendly portfolio tracker, a weekly buy/sell recommendation service and research reports on India's top companies.