Low risk premium has fuelled equity returns: RBI paper2 min read . Updated: 20 Oct 2020, 08:46 PM IST
- The paper provides some insight into the puzzle of rising stock prices despite sluggish earnings growth
- It also highlighted the risks posed by a rally driven by lower risk perceptions among investors rather than fundamental changes in earnings
Returns in Indian stock markets over the past few years have come on the back of falling equity risk premium (ERP) rather than earnings, this is according to a paper written by the Reserve Bank of India’s (RBI) officials from the Division of Financial Markets, published in the monthly bulletin for October.
The paper provides some insight into the puzzle of rising stock prices despite sluggish earnings growth. However, it also highlighted the risks posed by a rally driven by lower risk perceptions among investors rather than fundamental changes in earnings. The paper is written by the RBI employees but does not necessarily represent the views of the central bank.
The paper focused on estimating ERP, which is the extra return that investors demand in return for holding a risky asset. A fall in ERP denotes that investors have become more confident about the stock market.
“Decomposition of changes in equity prices indicates that the rise in equity prices from 2016 to early 2020 was mainly supported by a decrease in interest rates and ERP, with an increase in forward earnings expectations contributing to a lesser extent," the paper said. It went on to estimate a long-run ERP of 4.7% for Indian stocks from 2005 to 2020. The paper contrasts the ERP-led rally of 2016-2020 with the one during 2005-2008, which was led by earnings expectations. A higher ERP denotes a period of greater uncertainty, and hence, higher expected rate of returns in stocks.
Turning its attention to the covid-19-related stocks crash and the subsequent recovery, the paper attributed both to ERP rather than earnings expectations. “You can think of lower ERP as investors assigning higher valuations, that is, price-to-earnings (PE) multiples to stocks rather than their earnings going up. Therein lies the risk. Stock prices are being driven by investor confidence rather than earnings," said Vikas Gupta, founder, OmniScience Capital, a Sebi-registered investment advisory firm.
“With an ERP of 4.7% and a risk-free rate of 5.9% (based on the current 10-year government securities yield), the long-term return on Indian equities is 10.6%. If you consider the effect of long-term capital gains tax, it falls further to around 9.5%," said Ravi Saraogi, founder of Samasthiti Advisors, a Sebi-registered investment advisor.
The paper also highlighted the disconnect between stock prices and the real economy. “The regression results suggest that while the increase in ERP assumes significance in explaining the dependent variables, that is, the index of industrial production and GDP, decrease in ERP is insignificant in line with the economic theories. This is largely consistent with the divergence between the real economy and market observed in 2019, wherein ERP stayed low contributing to a surge in equity markets to record highs and GDP growth stayed muted. Overall, while the ERP has stayed below 4% levels since 2016, real GDP growth has remained below the 2016 level, which was 8.7 per cent," the paper added.
The paper echoed comments made by RBI governor Shaktikanta Das in August, highlighting that the buoyant stocks was disconnected from the real economy. “There will definitely be a correction, but we can’t say when," the governor had said in his remarks.