BackRBI paper attributes equity returns in India to falling Equity Risk Premium
The paper focuses 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 asset in question.
PremiumReturns in Indian stocks over the past few years came from a fall in equity risk premium (ERP) rather than earnings, a paper written by RBI officials from the Division of Financial Markets said on Monday.
The paper, published in the monthly bulletin for October, provides insight into the puzzle of rising stock prices despite sluggish earnings growth. However it also highlights the risks posed by the rally driven by lower risk perceptions among investors rather than fundamental changes in earnings. The paper is written by RBI employees but does not necessarily represent the views of the central bank.
The paper focuses 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 asset in question.
“Decomposition of changes in equity prices indicate that the rise in equity prices during 2016 to early 2020 was mainly supported by decrease in interest rates and Equity Risk Premium (ERP), with increase in forward earnings expectations contributing to a lesser extent," the paper says.
It goes 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 2005-2008 market which led by earnings expectations. Turning its attention to the covid-19 related crash and subsequent recovery, the paper attributes 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 yr G-Sec 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, Samasthiti Advisors, a SEBI Registered Investment Advisor.
The paper also highlights 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, IIP and GDP, decrease in ERP is insignificant in line with the economic theories. This is largely consistent with the divergence between real economy and market observed in 2019 wherein ERP stayed low contributing to surge in equity markets to record-highs and GDP growth stayed muted. Overall, while the ERP has stayed below 4 percent levels since 2016, real GDP growth has remained below 2016 level which was 8.7 per cent," the paper adds.
The paper echoes comments made by RBI Governor Shaktikanta Das in August highlighting that the buoyant stock market is disconnected from the real economy. “There will definitely be a correction but we can’t say when," the governor added in his remarks.
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