Since the onset of the pandemic in early 2020, newspapers have been lined with reports stating crashing markets, falling demand and recovery policies undertaken. But, one sector that showed opposing, positive behavior was that of the stock markets, as indices continually rose despite the negative impacts of the ongoing situation of the country.
In India, people are still reeling from the aftermath of the second wave of the COVID-19 pandemic as an even deadly third wave is expected to be on its way. One would expect markets to be bearish at this time, especially given the 7.3% contraction in the GDP in 2020-21.
However, Sensex is at an all-time high and is almost going to touch the 57,000 mark. In the absence of positive economic indicators, these signs stipulate the existence of a bubble in the stock market. So, what is a stock market bubble?
It is, in fact, an economic phenomenon that leads to an unprecedented rise in stock prices above their value in relation to some system of stock valuation, usually arising due to herd financial behaviour. The problem? Like all others, even such bubbles are expected to burst, bringing the market crashing down with it.
We know that stock markets and the GDP of a country are both systematic parameters of a countrys economic activity, and eventually its growth. So, while our GDP was falling, at times even to the negative percentile, we must evaluate the disparities that led to an opposing reaction in the stock markets.
The answer boils down to mainly two broad reasons. First, the stock market is not about the entire national economy, its just a piece of the economy including corporate profits.
Second, the natures of the economy and stock markets are different from each other while the stock markets are forward looking, an estimated prediction towards the future; the economic indicators like GDP are backward looking telling us what happened in the previous quarter or year, as per the available collected data.
Several investors believe that once the vaccines are readily available or the fear of further lockdowns dies down, the corporate profits would recover, leading to increased investments in hope for preferable returns.
The rationale behind skyrocketing markets
According to The New York Times, between May and June 2020, the top 25 % of the richest Americans cut their spending significantly. This evaluation is not surprising considering the tourism industry, and entertainment industry including shopping malls and restaurants, were shut down owing to safety restrictions enacted by governments, across the globe.
Since people no longer have the avenues for spending their surplus income, they are in turn, looking for options to invest it somewhere. Lowered interest rates by the central banks across the globe for economic recovery has provided a necessary incentive to these rich investors to invest in foreign stocks. This has resulted in a net inflow of 1.4 trillion, the highest since 2002 in Indian stock markets.
The second major reason behind the growth of the Indian stock market is the increase in digitisation, which has particularly benefited the existing and upcoming technological companies. This increased digitisation attracted foreign investments in companies like Jio, which bagged nearly half of all the private equity investments in India in 2020. Hence, the Sensex IT index outperformed the general Sensex index last year.
The third major reason behind this market trend is the increase in new and potential investors. During the lockdown of 2020, many students and young professionals showed their interest in the stock market as the number of
Demat accounts opened almost doubled, within a year across the country. New-age tech-brokerage firms launched new initiatives to familiarize the youth with stock market investing and attracted them with easy access to the online account opening process.
While stock market bubbles are often subjected to market crashes, it must be noted that one cannot accurately classify any behaviour as an economic bubble, until the market experiences a burst and inevitable plummeting of prices. Recently, the RBI, in its Financial Stability report asserted that stretched valuations of financial assets pose risks to financial stability.
Banks and financial intermediaries need to be cognisant of these risks and spill overs in an interconnected financial system. With an economy moving slowly along the path of recovery, a stock bubble could serve as the most potent risks of the Indian financial sector in the near future, calling for a need to exercise precautionary policies that may help cushion such an expected situation, and waiting for the markets to eventually show us their outcome.
Views are personal.