Last week RBI published its annual report in which they were deciphering the rational behind a possible 'Stock Market Bubble' in the Indian Stock Market.
The disconnect between the economy and markets is not new. Due to the deadly second wave, Tens of millions suffered, some of them lost their jobs, MSMEs went through severe pain, Financial companies are loaded by higher NPAs, theaters, parks, resorts all are empty but the market doesn't care much. It is a different beast and behaves apparently strangely without any empathy for the sufferings around.
A few of the stocks have even given returns upto 1200%. Stocks like Tanla Solutions, Adani Gas and Adani Ent. soared more than 1000% in just one year.
One thing is certain, whether it's a stock market or a particular stock, the correction becomes certain when fundamentals are not in line with the price movement and that's what we are doing.
Let me explain top concerns of RBI's annual report on Stock Markets:
1) Ease of Equity Risk Premium (ERP)
An equity risk premium is an excess return earned by an investor when they invest in the stock market over a risk-free rate. This return compensates investors for taking on the higher risk of equity investing.
So when the stock market is at all time low then EPR will be higher as they can expect more returns if it bottoms up. Similarly when the stock market is at all time high then EPR comes down and less investors would be willing to invest in stocks now. Within a year EPR tumbled from 6% to ~4% (Down by 33%).
We had observed almost same levels in 2007-08, and what happened next is the the history.
2) Deviation of Market P/E Ratio
The historic PE of Sensex is around 19, the current PE is 32. As per data, whenever it deviates much from its mean then it tends to repeat its path and intersect the mean. See the red lines.
In RBI's words:
3) The 'Quantitative easing (QE)' factor
Have you heard about 'Taper Tantrum'? (Read more)
In 2008 financial crisis the US Federal Reserve executed a policy known as quantitative easing (QE), which involves large purchases of bonds and other securities. In theory, this increases liquidity in the financial sector to maintain stability and promote economic growth. Stabilizing the financial sector encouraged lending, to allow consumers to spend and businesses to invest.
This method has been considered only usable as a short-term fix but if central bank feeds the economy for too long, there are unavoidable consequences. Tapering, which gradually reduces the amount of money the central bank pumps into the economy, should theoretically incrementally reduce the economy's reliance on that money and allow the Fed to remove itself as the economy's crutch.
RBI raised the same concern:
4) The FPI factor:
Interest rates in US is touching the ground , thanks to the virus. But slowly and steadily money supply would be decreased in a view to bring down the inflation.
Today, FPIs can borrow the funds in the US by taking advantage of lower interest rate and pump the money in the Emerging Markets like India.
It's quite self explanatory that whenever interest rates will come down, FPIs would gradually slow down the fund infusion and market would either be supported by domestic investors or come down (which is quite likely as per current valuations).
5) Sustainability of 'The Big Disconnect'
Reasons for market surge: Better than expected GDP data for Q2:2020-21, upward revision in India’s GDP forecast for 2020-21, upbeat IIP data for October 2020, hopes of a faster global economic recovery, upbeat corporate results for Q3:2020-21, encouraging reports for February 2021 on auto sales, GST collections, manufacturing and services PMI.
Reasons of market plunge: Fresh face-off between India and China at the border, weak global cues over the stretched valuations in US equities and cautious trading ahead of the Union Budget, surge in the US treasury yields, rise in crude oil prices and fresh spikes in COVID-19 cases in certain Indian states and finally imposition of fresh COVID-induced restrictions in some parts of the country.
As I mentioned, whether it's a stock market or a particular stock, the correction becomes certain when fundamentals are not in line with the price movement and that's what we are doing. RBI thinks the same, the disconnect won't sustain longer.
Hope we are clear with all the points which RBI raised in its annual report.