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On 18 December, 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.

The PE ratios of the Nifty 50 and other broader indices continue to remain at extremely high levels. 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. This is true for other indices as well. Interestingly, the overall net profit of listed companies in India hasn’t 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 covid pandemic, but even the overall net profit for 2018-19 was lower than that in 2010-11.

The quarterly net profit of listed corporates during July to September 2020 was at its highest level ever. But this was more on account of cost cutting by companies, on their employees as well as on the raw material front. Net-net, this increase in profit brought down the purchasing power of society as a whole, which will hurt future earnings. Further, the PE ratio remains high despite this jump in recent profits.

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. And to give them their due, the word ‘bubble’ doesn’t really have a firm definition.

The most famous definition of the word comes from the book Manias, Panics and Crashes, written by Charles Kindleberger and Robert Z Aliber: “The term ‘bubble’ is a generic term for the increase in prices of securities… that cannot be explained by the changes in economic fundamentals." With this definition, a bubble can be defined with full certainty only in hindsight.

So, how do we define a bubble in a way that allows us to identify one while it is inflating? William Quinn and John D. Turner do this in their book Boom and Bust: A Global History of Financial Bubbles. The authors compare a 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’s 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 stock broker’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". As Walter Bagehot, the famous editor of The Economist, once wrote: “John Bull can stand a great deal, but he cannot stand two per cent."

Real interest rates on bank deposits in India are currently in negative territory. This is primarily because of high inflation and also 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 6 February and 30 September 2020 was 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. Also, as a recent note by Ambit Capital points out, retail ownership of stocks stood at 9.1% in December 2019 and has risen to 9.8% since then. 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.

The heat for a bubble comes from increased speculation, particularly in the form of novice retail investors, many of whom trade only on momentum. Data from Ambit bears this out: “Retail till recently was contributing to about 70% of overall volumes."

The Duesenberry effect has added to it. Aliber and Kindleberger define this effect 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 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 don’t make for a stock market bubble, one doesn’t know what does.

Vivek Kaul is the author of ‘Bad Money’.

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