February 8, 2021 marked a new chapter in the history of Bombay Stock Exchange, on this day the BSE Sensex crossed 51,000 basis points in terms of its index. On December 18, 2020, the price to earnings (PE) ratio of the Nifty 50 stock market index reached an all-time high of 37.84. This was around 87% higher than the average PE ratio of 20.26 since 1 January 1999. This ratio is essentially the number of rupees that investors are ready to pay for every rupee of earnings over the last 12 months of the stocks that make up any index. The average yearly PE ratio of the Nifty 50 has been largely rising since 2013. This basically means that share prices have risen much faster than company earnings.Interestingly, the overall net profit of listed companies in India has not grown in many years.Their overall net profit in 2019-20 was lower than in 2007-08. Of course, 2019-20 profits would have been slightly hit by the pandemic, but even the overall net profit for 2018-19 was lower than that in 2010-11.
The stock market is supposed to discount expectations of future earnings to arrive at current prices, but when share prices have been rising much faster than earnings for more than seven years, it does make one wonder what exactly the market has been discounting. Despite this evidence, many stock market participants refuse to believe that the Indian stock market is now in bubble territory.The term ‘bubble’ is a generic term used to refer the increase in prices of shares that cannot be explained by the changes in economic fundamentals. To best explain this theory of a bubble, let us compare a stock market bubble to a fire. The three things required to start a fire are oxygen, fuel, and heat. Similarly, the three things required for a bubble are marketability, money and credit, and increased speculation. Let us see how this bubble triangle applies to the Indian stock market.
The oxygen for the bubble is marketability. There was a time when one had to go to a stockbroker’s office or call one up to buy or sell stocks. In the last few years, the rise of trading apps and cheap Internet access has led to the increased marketability of stocks. They can be bought and sold anywhere. The rise of zero-cost/ low-cost brokerages has added to this.
The fuel for a bubble comes from low interest rates and loose credit conditions. Real interest rates on bank deposits in India are currently in negative territory. This is primarily because of high inflation and due to the collapse in lending across the country’s economy. Further, the Reserve Bank of India has flooded the financial system with money. The total liquidity support announced between February 6 and September 30, 2020 was Rs 11.1 trillion. Interest rates are negative or close to zero across large parts of the world. This has pushed both large and retail investors to invest in stocks, in search of higher returns.
Foreign institutional investors have invested $28.66 billion in Indian stocks since April, the highest they ever have during a single financial year. Further, 6.3 million new demat accounts were added during April to September this year, as compared to 2.74 million accounts during the corresponding period last year.
Thirdly the heat for a bubble comes from increased speculation, particularly in the form of novice retail investors, many of whom trade only on momentum. The ‘Duesenberry effect’ has added to it. This effect can be best defined as a situation where individuals who get used to a certain level of income find it difficult to reduce their spending when their income level declines.The spread of the COVID-19 pandemic has led to job losses and a decline in incomes, leading many retail investors towards the stock market in the hope of making a quick buck to maintain their income levels. If all these factors do not make for a stock market bubble, one does not know what does.
To sum up, the stock market index be it BSE Sensex or the NSE Nifty is currently trading in uncharted territory, what is alarming is not the speed at which it is scaling new heights, but an absolute absence of fundamentals be it in terms of the fall in corporate earnings along with an even greater decline in GDP reflecting the dreadful macroeconomic state of the economy. Its time we wake up to the reality before this bubble bursts. Else in this testing time we will risk losing everything that we have worked for in our lifetime.
