The Reserve Bank of India has raised some concerns about the bubble in Stock Markets in its annual report published quite recently as the prices of risky assets surged across countries to record high levels during the year largely on account of unprecedented measures adopted by the governments and the central banks worldwide in response to a sudden and devastatingly swift onslaught of the covid19 pandemic.
These measures comprised of additional fiscal spending, foregone revenues, capital and debt injections, contingent liabilities, and liquidity/ funding for lending adding up to US$ 16 trillion or 15.3 per cent of world GDP across the globe. And this was really a big fat stimulus as the governments and the central banks desperately endeavored in tandem to save the lives and the livelihood of the people.
In India, too, a calibrated policy stimulus, which was initialized to provide direct assistance in cash and kind to the poor and promptly broadened to include a comprehensive package (AatmaNirbhar Bharat) had similar objective, i.e., to provide support to the various sectors of the economy.
The stock markets zoomed to unprecedented levels
The size of the exceptionally high fiscal and monetary stimulus cumulated to unprecedented level of 15.7 per cent of GDP in the year 2020-21 enthused market sentiments following positive news on the development of and access to vaccines and the end of uncertainty surrounding US election results.
The widening gap between stretched asset prices relative to prospects for recovery in real economic activity, however, emerged as a global policy concern (BIS, 2020; IMF, 2020) and Indian stock market was no exception. The equity prices zoomed to record highs, with the benchmark index (Sensex) crossing 50,000 mark on January 21, 2021 and touching at a record level of 52,154 on February 15, 2021. This was an impressive 100.7 per cent increase from its pre-lockdown plummeted level (i.e., since March 23, 2020) and a 68.0 per cent increase over the year 2020-21. According to the RBI, this order of asset price inflation in the context of the estimated 8 per cent contraction in GDP in 2020-21 poses the risk of a bubble.
Theoretical explanations for the bubble
RBI refers to the recent Literature on the subject siting Tiryaki et al. (2019) and Khan and Khan (2018), which highlights several fundamental determinants of equity prices, viz., GDP growth, inflation, and money supply. Further, RBI sites that an auto-regressive distributed lag (ARDL) model estimated by regressing stock prices (Sensex) on money supply (M3, as a proxy of liquidity), the economic outlook (OECD composite lead indicator – CLI) and foreign portfolio investments in the secondary equity market for the period April 2005 to December 2020 indicated that the stock price index is mainly driven by money supply and FPI investments. Although economic prospects also contribute to movement in the stock market, but the impact is relatively less compared to money supply and FPI. On the basis of this assessment, RBI opines that liquidity injected to support economic recovery can lead to unintended consequences in the form of inflationary asset prices.
Two-way price movements are possible going forward
According to the RBI report, the possibility of disruption caused by bubbles forming in asset prices provide a reason to restrain the liquidity support which may have to go through calibrated unwinding process once the pandemic waves are flattened and real economy is strongly back on recovery path.
Apart from the fundamentals, however, the part of present valuation of Sensex to the extent, as in the past, which is supported by improved corporate earnings, can be seen as rational. The stock market valuation can also be assessed by comparing the price-to-earnings (P/E) ratio with its historical. RBI finds that the deviation of the actual P/E from its long-run trend shows that the ratio is overvalued. In addition, the measures of dividend yield also signal that the markets are getting overpriced. A decomposition of changes in equity prices indicate that the rise in equity prices during 2016 to early 2020 was mainly supported by a decrease in interest rates and Equity Risk Premium (ERP), with increase in forward earnings expectations contributing to a lesser extent. Thereafter, a spike in ERP on COVID-19 concerns initially contributed to equity prices declining sharply to compensate for increased risks. However, equity prices registered an impressive recovery, subsequently, aided by easing of ERP. Currently, dividend yields have fallen below their long-term trends. As such, the RBI study concludes that two-way price movements are possible going forward.
Investors may have to constantly weigh the positives with negatives
The RBI annual report mentions that a massive Rs. 1.5 lakh crore production-linked incentive (PLI) scheme announced by the government for 10 manufacturing sectors and a record high FPI inflow were also the factors that caused an upsurge in the domestic equities by the end of calendar year 2020. Besides, a better-than-expected GDP data for the second quarter of the fiscal coupled with an upward revision in India’s GDP forecast for 2020-21 by the Reserve Bank and various global agencies, boosted the market sentiment. The markets also feasted on upbeat in the Index of Industrial Production (IIP) data for October 2020 coinciding with the hopes of a faster global economic recovery after the passage of the US stimulus package and the Brexit trade deal much around the same time period.
However, the reports of a new strain of coronavirus in several countries and the resultant imposition of fresh lockdowns and travel restrictions dwindled the market sentiments. Against this backdrop, the domestic markets remained largely volatile in January 2021 as investors seemingly weighed the positives of the roll-out of coronavirus vaccines in the country and upbeat corporate results for the third quarter of the fiscal 2020-21 against the persistent rise in COVID-19 cases across the globe. Besides, there were concerns over reports of a fresh face-off between India and China at the Indian border, weak global cues about the stretched valuations in US equities and the likely structure of the Union Budget 2021-22.
The markets shred the weak momentum towards the end of January 2021 and the Sensex achieved a fresh high of 52,154 on February 15, 2021 due to favourable budgetary proposals, optimistic outlook on revival of GDP growth by the Reserve Bank and positive cues from global markets. But then, again, the markets declined towards the end of the month following a surge in the US treasury yields, rise in crude oil prices and fresh spikes in COVID-19 cases in certain Indian states.
However, the release of positive GDP data for the third quarter of the year 2020-21 along with reports of increase in auto sales, GST collections, manufacturing and services PMI for the month of February lifted the market sentiment again in March, 2021, only to be sobered later to some extent on fresh concerns over inflation and imposition of another round of COVID-induced restrictions in some parts of the country.
Moving ahead the investors have to tread with extreme caution as they need to assess both the fundamental and technical analysis outcomes weighing constantly the global and domestic economy on one hand and the industry specific cues on the other hand.
References as sited by RBI Annual Report:
- International Monetary Fund (2020), ‘Global Financial Stability Report: Bridge to Recovery’, October.
- Khan, J., & Khan, I. (2018), ‘The Impact of Macroeconomic Variables on Stock Prices: A Case Study of Karachi Stock Exchange’, Journal of Economics and Sustainable Development, 9 (13), 15-25.
- Bank for International Settlements (2020), Annual Economic Report, BIS.
- Tiryaki, A., Ceylan, R., and Erdoğan, L. (2019), ‘Asymmetric Effects of Industrial Production, Money Supply and Exchange Rate Changes on Stock Returns in Turkey’, Applied Economics, 51(20), 2143-2154.