New bull market or new bubble?
Opinion seems to be evenly divided over how to describe the surge in share prices over the past few months. There are fundamental reasons why investors have rediscovered the joys of equity investing: Risk premiums have reduced, there are some signs that economies are stabilizing and corporate results in India have been surprisingly good.
Illustration: Jayachandran / Mint
Yet, none of this can justify current valuations. The Bombay Stock Exchange Sensex is currently trading at around 20.64 of historical earnings. That’s expensive, going by historical standards and the current growth prospects of the Indian economy.
This recent surge in share prices has helped the economy in two clear ways. One, lots of green on the stock ticker helped clear away the glum mood in urban India, where pessimism assumed that the economy was in worse trouble than it actually was. Two, companies have used higher share prices to raise capital, cut leverage and repair balance sheets.
But that does not take away from the fact that most of the current surge in share prices is because of the flood of global liquidity that has been released by central banks since September 2008 to prevent a full-scale meltdown of the global financial system. And a lot of this liquidity has come into asset markets, both shares as well as commodities. This is Bubble 2.0.
There are several factors that investors should take on board before euphorically jumping into the foaming waters. One, the economic downturn is bottoming out, but that does not mean that a strong recovery is necessarily around the corner. It’s impossible for an economy to keep shrinking to zero. But that does not mean it will quickly regain its previous dynamism, especially given the damage to individual and corporate balance sheets around the world.
Two, asset price inflation could eventually be followed by consumer price inflation. It is not a great danger right now. Most advanced countries are close to deflation and even countries such as India are more worried about food price rather than manufactured goods inflation. But central bankers across the world have made it clear that there will come a time when incredibly loose monetary policies will have to be discontinued.
The road ahead promises to be a rocky one, with stuttering growth, creeping inflation risks and overextended fiscal systems. Investors seem to be pricing companies as if they expect a quick return to the boom years of 2003-07. Our guess is that this is a case of unnecessary optimism.
Are investors overvaluing share prices? Tell us at email@example.com