Vachi Agarwal (St. Xavier’s College, Kolkata

VACHI AGARWAL

St. Xavier’s College. Kolkata

WILL THE STOCK MARKET END IN TEARS

“Double, treble, quadruple bubble, watch the stock market get into trouble...”

This famous adage by Garth Nix appropriately warns about the anatomy of a stock market bubble staring India and the prospects of this excessive valuation to end in tears.

The domestic stock markets have touched record high levels and generated high double-digit returns during 2020-21 even as the country’s economy continued to face disruptions on the back of unparalleled levels of monetary and fiscal stimulus. Between 6th February to 30th September 2020, the Reserve Bank of India (RBI) had announced a total liquidity support of ₹11.1 trillion. Expansionary monetary policies had been adopted worldwide with an aim to bring down interest rates to near-zero levels, drive economic activities through provision of cheap debts and massively scale up the purchase of assets resulting in a rise in direct participation of retail investors and witnessing an opening of over 1.43 crore Demat accounts during 2020-21.The availability of cheap money encouraged increased speculation from novice retail investors and high Foreign portfolio investment (FPI) inflow ,thus, contributing to the rising stock prices. With the temptation to make hay while the sun shines, Initial Public Offers (IPOs), Follow-On Public Offers (FPOs) and rights issues increased manifold by 43.1% during 2020 -21. According to RBI, the high amount of liquidity that has been injected into the economy to aid economic recovery has had “unintended consequences” in the form of inflationary asset prices. India’s equity prices continued to surge, with the benchmark Sensex crossing 50,000 in January,2021 and on February 15,2021 Sensex touched a peak of 52154, a 100.7% increase from the slump just before the beginning of the nationwide lockdown on March 23, 2020. The BSE Sensex surged by 68% to close at 49,509 while the Nifty 50 increased by 70.9% to close at 14,691 on March 31, 2021.[1] This continuous rise in asset prices has been in stark contrast to the estimated 8% contraction in GDP in 2020-21, thus, posing the risk of a bubble formation.

A stock market bubble refers to an economic bubble wherein market participants inflate share prices to levels exceeding the company’s fundamental value including earnings and assets by a significant margin. It is created on the basis of speculative optimism or increased demand, rather than the real value of the financial assets. The central bank of India noted that the deviation of the actual Price/Equity (P/E) ratio from its long-run trend reflects that the ratio has been overvalued, while measures of dividend yield also signal that markets are getting “overpriced”. According to the annual report prepared by RBI, Sensex is currently trading at a P/E ratio of 31.6 against a 5year average P/E of 24.53. The turn in market sentiments “following positive news on the development of and access to vaccines and the end of uncertainty surrounding US election results” have also led to increased valuation of equities.[2] This newfound liquidity fueling the stock prices in an environment where the real economy is collapsing has left little scope of doubt to examine whether the current stock market rally is rational or not. In India, with the unemployment rates sky-rocketing, Debt to GDP ratio spiking and budget deficits broadening while the stock markets are still presenting a buoyant image, the country’s economy is threatened with the

possibility of a bubble burst. Sooner or later, these bloated asset prices shall exert inflationary pressures on the economy causing central banks to hike interest rates, lower the circulation of money and thus, dampen expectations of future bubble price appreciation. Massive sell offs causing decline in prices shall lead to greater negative effects on equity return. The stock market shall be in a state of mayhem, derailing any hope of recovery. The financial stability of the economy shall be brutally sabotaged with no significant improvements in economic growth. To avoid wealth erosion and better navigate the bubble, an understanding of the five stages of a financial bubble i.e., displacement, boom, euphoria, profit taking and panic is essential. Displacement is the first stage that occurs when investors are captivated by a new paradigm, such as historically low interest rates. In 2020, RBI announced a repo rate cut of 40 basis points to 4% which is the lowest benchmark interest rate India has had since 2000 to mitigate the impact of Covid-19. Following a displacement, prices rise slowly but eventually gain momentum as more and more participants enter the market leading to a spur in speculation activities. During this boom phase, escalating market prices grab the eyeballs of many individuals. Cheap credit and quantitative easing program fuel the boom to levels such that in March 2021, the overall debt held by Indian households were valued at ₹43.5 trillion approximately. With valuations going through a roof and too many people itching to jump onto the bandwagon, the investors are lulled into false sense of security that should they wish to sell, they will easily find someone who would be willing to pay more. The euphoria stage is characterised by this conviction which leads to investments that are disproportionately higher than an individual’s risk appetites. As prices reach Utopian levels, some investors who are receptive to the warning signs of a possible bubble burst in near future start selling positions to lock in gains at the profit-taking stage. With passage of time, the bubble perforates which acts as the catalyst for economic recession. In the panic stage, asset prices descend rapidly as supply overwhelms demand. Investors and speculators faced with plunging values of their holdings become willing to liquidate it at any price. As RBI flags risk of a bubble in Indian equity markets, the question that requires addressal is how should retail investors manoeuvre their way in a market that seems to disregard the turmoil on the economic front? While it is impossible for investors to insulate themselves completely from volatility, it is advisable to not let exuberance get the better of investment fundamentals i.e., diversification, asset allocation and rebalancing of portfolios. Another important strategy to safeguard investment from fluctuations is through staggered investments over time and Systematic Investment Plans (SIP) in a mutual fund spread with low correlation, in accordance to the speculator’s risk taking abilities. In the long run, SIP investments in mutual funds due to the benefit of rupee-cost averaging can wipe out the creases left by the bubbles. At the moment, the Indian stock market seems to be rising rapidly after a period of hesitation during the second wave. Minor corrections are expected throughout the year, depending on the evolving Covid-19 situation, the pace of recovery of global and domestic economies and developments in global financial and liquidity conditions. Thus, the efforts undertaken by the central bank to keep interest rates lower and engage in unconventional monetary policy to curb the economic downturn has emerged as a global policy concern. Given the evident disconnect between the glooming economy and booming markets, it is certain that the bloated asset prices may be coming to an end, leaving a trickier future impending on the horizon. With frothy markets sparking worries of bubbles in Indian assets, the only question that remains unanswered is, when?

References

1.India Today, 2021, RBI warns of stock market bubble: Should investors be worried?, viewed 25 July 2021, <https://www.indiatoday.in/business/story/rbiwarns-of-stock-market-bubble-should-investors-be. worried-1809096-2021-05-31>.

2.Modak, S 2021, Rising stock markets amid GDP contraction pose risk of a bubble, says RBI, viewed 26 July 2021,<https://www.business-standard.com/article/ markets/rising-stock-markets-amid-gdp-contractionp o s e s - r i s k - o f - a - b u b b l e - s a y s - r b i 121052701358_1.html>.

3.Curran, E 2021, Pandemic-Era Central Banking Is Creating Bubbles Everywhere, viewed 27 July 2021, <https://www.bloomberg.com/news/features/2021 -0 1-2 4 / c e n t r a l-b a n k s-a r e-c r e a t i n g-b u b b l e severywhere-in-the-pandemic>. 4.Khan, A 2021, Beware the equity market bubble: Experts raise the red flag, viewed 27 July 2021, <https:// www.newindianexpress.com/business/2021/jun/16/ beware-the-equity-market-bubble-experts-raise-thered-flag-2316821.html>.

5.Bose, P 2021, India’s equity market bubble may burst s o o n , v i e w e d 2 5 J u l y 2 0 2 1 , < h t t p s : / / www.thehindu.com/opinion/op-ed/indias-equitymarket-bubble-may-burst-soon/article35433609.ece >.