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Equity markets under a spell of irrational exuberance

Sustained FII and SIP inflows seem to be pushing share prices higher than reality can possibly justify

While the models of most economists that assess the pandemic’s impact on growth and predict the pattern of an economic recovery (being V-shaped or U-shaped) have failed on consistency, there is one trend that is following an unswerving pattern across the world: a steep rise in asset and stock prices.

Supply-side restrictions are making corporate earnings tank and corporate debt inflate, even as a demand-side slowdown is worsening and higher unemployment is causing greater risk averseness. So, how can share prices continue to soar?

Indian equity markets added more than $605 billion over the last few months. The benchmark share price index, the BSE Sensex, has risen 45%, and is trading at more than 22 times last year’s earnings. The forward-earnings ratio would be higher.

A growing disconnect between capital markets and the real economy signals the formation of a bubble, or a “mania" in crisis terminology. This can’t be explained by any logical deduction or objective faith in the market’s fundamentals, or by the strength of a recovery, but by an irrational exuberance among investors amid short-term capital inflows from foreign institutional investors (FIIs), some of it “hot money", and those from systematic investment plans (SIPs).

This may be explained by the presence of a stable government, projecting a narrative of economic reforms, along with a flexible and expansionary monetary policy approach of the central bank since the lockdown. This encouraged investors not to pull out investments in panic and helped keep stock markets stable. Still, the rally is too steep for any rational justification.

There could also be exogenous factors explaining this trend. The low global cost of capital (or cheap-dollar money), with lower interest rates made available across the world through the US Federal Reserve’s “lender of last resort" outreach (and by other central banks), combined with optimism in India’s medium- to long-term growth prospects, vis-a-vis emerging markets, could be attracting FIIs.

The real question is: Is such a rally sustainable? The short answer is no.

An equity market rally must be backed by strong macroeconomic fundamentals and rising corporate earnings. That doesn’t seem to be happening at all.

So, what are the underlying reasons that explain such irrational (pandemic-induced) behaviour among investors?

Nobel Laureate Robert Shiller argues: “The more economic fundamentals and market outcomes diverge, the deeper the mystery (of the financial market rally) becomes, until one considers possible explanations based on crowd psychology, the virality of ideas, and the dynamics of ‘narrative-epidemics’. After all, stock market movements are driven largely by investors’ assessments of other investors evolving reaction to the news, rather than the news itself."

One such illustrative narrative-driven phase seen in March signalled an irrational bump up in investor optimism when fiscal-monetary policy instruments went all out to spend and generate liquidity to support firms and households. Many, who didn’t even read, follow, or understand the details of the CARES Act, or the steps taken by the Fed, invested big money and entrusted their faith in an economic recovery based on recollections of past crises responses and outcomes.

This pandemic, however, has created a new crisis “narrative", where decisions based on past crisis narratives (say, the 2007-08 subprime crisis of the US) have not helped.

Interestingly, in India’s case, there is another factor that might be keeping share prices and stock-markets afloat: automatic flows from SIPs.

Total SIP accounts have risen from 31.4 million in March to 32.7 million in July, signalling rising confidence in mutual fund investments. Despite a slowdown, money coming in via SIPs has remained strong at around 7,831 crore in July.

Why might that be? Perhaps because planned investments like SIPs tend to get sticky over time. Most investing in them, largely from the upper-middle income class, process these payments through auto-debits from their bank accounts, letting the investment money flow in spite of economic realities on ground, or a change in narrative.

It is also true that despite the recent fall in real incomes for many urban households, and an increasing rate of unemployment seen among the salaried class, the disposable income for many (those still employed) has gone up since the lockdown came into effect, as many other overhead expenses— say, on travel, accommodation, eating out, cinema-going, shopping at malls, etc.— have drastically come down. This might be encouraging more Indians to save in uncertain times and some to increase their investments in low-risk mutual fund schemes through SIPs.

However, if the real economic situation continues to stay grim, such trends and micro-patterns of household investments might see a change, exposing the vulnerabilities of Indian financial markets. One can already see a shift in asset preference, especially among semi-urban and rural households, towards gold-related investments. This will rise as economic uncertainty grows. Any shock that triggers a sudden change in investor attitudes, causing a correction in asset prices, may lead to a deep financial crisis. Given today’s irrational exuberance, this seems likely in the months ahead.

Deepanshu Mohan is associate professor of economics at O.P. Jindal Global University

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