Last year Colombo stocks rose 120 percent, ending the year as the world's second best performing market. Sri Lanka emerged from a 30-year war in May 2009, raising optimism about future growth.
But increasingly there are fears of a stock market bubble, amid lower-than-usual interest rates and excess liquidity in the banking system.
Sri Lanka's securities regulator has imposed price caps to curb excessive speculation and also warned brokers not to extend margin credit to clients.
Central Bank Governor Nivard Cabraal told LBO in an interview that stocks were adjusting to depressed prices during a long-drawn out war and meeting pent up demand.
He said there was no strong evidence pointing to an asset-price bubble as bank lending has been prudent.
"That is why we are not unduly worried about that," Cabraal said. "At the same time there was a depression in all our prices for a long time, particularly as a result of the conflict so naturally there will be a pent up demand that will be generated in this initial period.
"I think the initial period has to a great extent been achieved. That could have been thought to be a bubble.
"So hopefully the rises hereafter will be less than what we have experienced in the past 12 to 18 months."Sri Lanka's economy was estimated to have grown by 8.5 percent in the second quarter. The central bank has raised the year end growth forecast to between 7.5 to 8.0 percent. Treasuries rates are below 10 percent, and inflation is below 6.0 percent.
Last Monday Sri Lanka raised a billion dollars for 10-years at 6.25 percent, lower than the 7.4 percent paid for a 500 million dollar 5-year issue last year. The offer was oversubscribed 6.3 times. The country is boldly going where it has not gone before.
But there have been other signs of irrational behavior in equities. Some stocks have been trading at triple digit price to earnings ratios, especially in hotels. Stock splits are too numerous to count.
Amal Sanderatne, head of Frontier Research, a consultancy, told a group of senior executives at the LBR-LBO chief executive officers forum that stocks values were "stretched".
"In my opinion the market is overheated," Sanderatne said. "The valuations are the highest in Asia. Forward multiples are 19 times earnings; far higher that we have ever been, except perhaps in 1993."
In November 2008, before the war ended Sanderatne authored a report saying "we are Sri Lanka bulls". He predicted that the index would go to 5,000 points. At the time the Colombo All Share Index was 1,900. But on Friday the index topped 7,000 points.
On Friday Sri Lanka's market price earnings ratio, on historical profits hit 28.4 times, according to Colombo Stock Exchange data. In the early 1990s Sri Lanka's market P/E soared over 30 times before the bubble burst.
Singapore, one of the fastest growing economies, is trading at 12.8 times historical and estimated 14 times next year's earnings, according to Bloomberg data. Malaysia is trading 17.8 times historical earnings and 14 times forward.
Troubled Pakistan is trading at 9.94 historical and 6.68 times next year. India's Sensex Index is trading at 19.95 times historical earnings and an estimated 16 times forward. Australia, the fastest growing country among developed nations, is at 19.11 times historical and 11.78 foreward.
The stock rally has been largely domestic driven. Foreign investors have been net sellers of over 15 billion rupees so far this year. In early 2010, hedge fund investor Raj Rajaratnam was selling out.
On Friday when the benchmark index topped 7,000 points foreigners sold 1.8 billion rupees of stocks and bought 256 million. A day earlier foreign selling was 854 million rupees and purchases 205 million.
Among the buyers of foreign owned stocks have been the Sri Lankan state banks, which are flushed with liquidity and there are no large private sector projects to finance at the moment.
The central bank managed, Employers Provident Fund of private citizens also entered the stock market in a big way and is now sitting on big capital gains.
"The market overall may be looking overheated," says Channa Amaratunga, head of CT Capital.
"But there is value to be found in selected shares. And there are no signs of domestic liquidity drying up. If there is a bubble, what is the trigger that will burst a bubble?
At the moment cash from maturing Treasury bills, even from private citizens are going into stocks. A few percentage points of the 800 billion rupee EPF fund is invested in stocks.
Usually, bubbles are fired by expanding money supply. They burst when monetary policy is tightened or - before the central banking era - when banks collapsed or stopped extending credit. But there is usually also a visible trigger.
With foreigners becoming less important in the market external shocks may not trigger a sell-off. The SEC has asked brokers to end margin trading facilities by January, which can trigger some selling. But there may be state funds around to pick up the slack.
The recent global downturn happened after the Federal Reserve fired a bubble with prolonged 1.0 percent interest rates and which collapsed when interest rates were raised to 5.25 percent.
But Sri Lanka's interest rates are on the way down. Governor Cabraal says the inflation outlook is 'benign'. The only tightening that is happening is a strengthening rupee, and some mopping up of excess liquidity from time to time.
The proceeds of the billion dollar bond are also expected to reduce pressure on domestic credit markets and may indirectly support stocks. It may also give more room to the EPF to buy stocks instead of government bonds.
Mark Twain, an American author has said that October is one of the "peculiarly dangerous months to speculate in stocks."
The 1929, 1987 and 2008 crashes had happened roughly in October.
According to Twain the other months are July, January, September, April, November, May, March, June, December, August, and February.