Alex Fak in Moscow -

Opinions are divided on where Russia’s stock market is headed next.

Russia’s stock market has just finished its third massive re-rating in just five years. Each time the market’s valuation has more than doubled over a period of about 18 months – this time it has gained some 140% between September 2004 and the end of last year.

The re-rating came to an end in March after the RTS index briefly touched a recordbreaking 1500, but the market ignored the analysts' “Stop” sign and showed no sign of stopping. By the start of May it had reached 1650. Opinion is widely divided over where the market goes from here, but even Brunswick UBS’ Al Breach’s optimistic yearend target of 1700 is starting to look conservative, while Aton Capital’s pessimistic prediction of a collapse to 1250 is looking unlikely.

BUBBLE WARNINGS

Even as the state gets set to join the IPO rush later this year with the privatisation of firms like Rosneft, the Kremlin is advising caution in an effort to curb volatility and several ministers are warning that Russia is on the edge of a stock market bubble.

Stock market watchdog boss Oleg Vyugin added warnings that market exuberance could lead to volatility that would be bad for economic development - and the price of government- owned stocks due to debut this year.

“Unfortunately, the infrastructure of Russia's securities market has developed in a speculative way,” says Vyugin.

The Russian market's capitalization has reached $604 billion, or 79% of GDP - a sixfold increase in as many years. In places like Thailand and South Africa the market cap has gone as high as 200% of GDP, but Vyugin says these markets are very volatile and would prefer the value to settle at 40%- 60% of GDP.

Fast growth creates growing room and everyone, except Renaissance Capital, expects the economy to expand faster than the government’s offical target of 6%.

WELL OILED

Oil prices have been the most important variable, as oil companies account for the lion’s share of the market’s value. Brunswick UBS’ Breach says the market is still pricing oil at $40 a barrel, despite the fact that almost everyone’s estimates for this year are over $50.

And this was before oil prices topped $75 a barrel in April. Alfa Bank’s Chris Weafer believes that a barrel of Brent, on average, will fetch $55 or more – the figure equal to OPEC’s target and in line with Cambridge Energy Research Associates’ “most likely” scenario of around $59.

However, many observers are less optimistic about the more traditional factors that affect market performance, which will be trumped by external factors entirely beyond the government’s control.

Weafer points out that plugging an assumption of $50 per barrel for the average price of Brent into the models churns out an RTS year-end prediction of 1400 points. But raising that assumption by 20% - to $60 per barrel – raises the RTS by only another 100 points.

Estimating country risk is one of the hardest variables to pin down and taking the spread of Russian sovereign bonds over the benchmark US Treasuries is often used as a proxy. Amazingly, the spread is expected to narrow to nothing this year and may even flip - making Russian bonds cheaper than US bonds for the first time ever.

“That would imply investing into the Russian economy is safer than investing in the American economy, which is clearly a fantasy,” says Roland Nash of Renaissance Capital.

“What it really means is that bond spreads are no longer a good proxy for country risk.”

But the biggest unknown is the impact of rising global interest rates. By the start of May the yield on long-term US Treasuries broke through 5% for the first time in years, threatening to suck cash out of the emerging market universe back into the more traditional markets.

“If during the next global credit crunch investors find it more comfortable to stay in Russia, it will mark a turning point,” says Nash. “If superior growth outweighs low risks, maybe it is time to drop the market’s somewhat disparaging moniker ‘emerging’.”