BSE Sensex, one of India’s prime stock market indexes fell nearly 2.5% this week, the worst weekly showings in the last eight months. This was because of concerns relating to RBI ending its easy money policy. Let’s first take a look at what has happened till now.
The stock markets crashed in March last year, taking the Sensex to 27,000 points, thanks to the covid outbreak and a stringent lockdown. Since then the markets have rallied big time, with a rise of whopping 122% in less than one and a half years: Sensex crossing 60,000 points earlier this year.
All this was possible because of the cutting down of interest rates all over the world including India which ensured a heavy supply of money from central banks. This was done so that people, corporates, and governments could borrow easily and spend to keep the demand-supply cycle running. But, all this money found its way into the stock markets looking for some returns. This, in economics, is referred to as ‘Hot Money’.
In India, Foreign Institutional Investors (FIIs) and domestic investors were the two main factors behind this rally. Interest rates on fixed deposits have been below inflation in the last year which has pushed people to invest in stock markets. This can be derived from the fact that record 10.7 million new demat accounts were opened up between April 2020 and January 2021. Other than the low interest rates, the rise of financial influencers or FinFluencers has also talked up the market.
This rally has also been disconnected from the reality of the Indian Economy. At a time when the economy has not been performing so well, stock markets are touching their peak. The price-to-earnings ratio has been rising for years now and has touched a record high of 31.9 for Sensex this year. This basically means that for every ₹1 that the companies in Bombay Stock Exchange earn, investors are willing to pay ₹31. A justification given to this is that investors are discounting the future. They expect the company earnings to boom after some time when people are vaccinated and the festival season arrives. But, the fact that the P/E ratio has been rising continuously for years now clearly shows us that stock prices have gone up but earnings have remained quite the same.
Now, earlier this year, American Central Bank Federal reserve’s chairman Jerome Powell hinted that the Fed would go slow on its easy money policy. The US has largely contributed to the high liquidity in the world market by printing trillions of dollars in the aftermath of covid. Its signal for the u-turn has caused the FIIs to slow down pouring money into India’s financial markets. According to a report in the Mint, in October, FIIs sold around $1.21 billion worth of shares in India.
Now, similar hints by RBI may have the same effect on domestic investors. Apart from that, the massive amount of newbie retail investors who has no experience of falling markets may panic at this time and take out their money. This will result in a huge collapse.
This is not to say that we would certainly see a bubble burst, but what one can safely say is that stock valuations have gone through the roof. Stock prices are nowhere near to where they should be. India’s current market cap to GDP ratio is 112%, against the historic average market cap to GDP ratio of 76%.
As an investor, one should definitely have a close eye on it.