Why it may not be the best time to buy stocks
The following headline gives a sense of the current dissonance between the economy and the stock market: “Multiplex stocks bounce back in India despite empty theatres.”
The economy is in dire straits. It is likely to contract by several percentage points during the current financial year (2020-21). On the other hand, the stock market is rising merrily. In the current calendar year, the Sensex, from a peak in mid-January of close to 42,000, fell to below 26,000 in late March when the countrywide lockdown was imposed, but it has now mostly recovered that fall to hover around just below 40,000.
Something has gone beyond rational expectations. The markets are in a phase of ‘irrational exuberance’, to use the phrase typically deployed to describe an unsustainable bull run.
Who said this? None other than the Reserve Bank Governor, who, of course, did not use the phrase but expressed similar sentiments. “The stock market is very buoyant and it is definitely disconnected with the real economy.” He added that the market “will certainly witness correction” but when this “will take place, it is hard to predict.”
What the Governor was doing was sending a signal to the market to curb its exuberance, but it was not listening, at least not till the time of writing.
Why is this happening? There are several reasons, but the most important is liquidity which is sloshing across the free market economies of the world created by both monetary expansion — central banks lowering interest rates — and governments upping spending.
In order to counter the massive blow delivered by the pandemic, central banks across the world have made available a huge amount of liquidity so that the financial sector can borrow easily and pass on cash to businesses and individuals for them to go forward and spend. Without that, there will not be sufficient demand to revive economic activity. But a lot of that liquidity is finding its way into the stock market to finance speculation.
There is one milestone right ahead. Come August-end, the loan moratorium will end. Those who were postponing repayment of their loan installments will have to resume repayment. Many will not be able to, and so, the RBI has allowed a one-time restructuring of loans to both corporates and individuals.
Essentially, all the overdue interest will be added to the principal outstanding and a new repayment schedule will be laid down. But there are conditions and not all will be able to avail themselves of this facility. So, many will be unable to keep repaying their loan which will be rendered irregular and the loaning institutions will have to start the process of treating these loans as stressed assets. The upshot? Some more trouble ahead. So, the economy will continue to be in troubled waters.
Another source of liquidity is the foreign money coming in. Why is this so? Central bank policy rates across mature economies are lower than those in India. The US Federal Reserve’s benchmark rate is 0-0.225 per cent. On the other hand, the RBI’s repo rate is now at 4 per cent. So, this interest rate differential is also a factor in the foreign money coming in. FII inflow into the country and stock markets is sharply up, even as domestic institutions are taking money out of the stock markets.
Some domestic institutions are getting into bonds issued by corporates who now have some cash. This can probably be ‘parked’, so to speak, by the corporates in a stock market going up, waiting for the time when demand picks up and businesses can scale up their operations and need more institutional finance.
What lends credibility to the feeling that there is a good bit of speculation is in the difference in the behaviour of prices of big companies on the one hand and medium and small companies on the other. In the last one month, the prices of the latter have gone up much more than those of the former.
Stocks of large companies — with bigger market capitalisation — are more widely tracked by analysts and better governed compared to smaller companies. The large companies’ earnings estimates carry greater credibility. Hence, their stocks are less likely to face speculative demand. A whole lot of small investors, guided by ‘tips’, is picking up the stocks of smaller companies.
There are, of course, counter-arguments suggesting that the speculative sentiment is being overrated. Those arguing along these lines point to a small subsection of companies which are actually doing well. They are healthcare, vaccines, work-from-home, self-reliance and, of course, the technology sector. Software majors have famously weathered the twin storms hitting their overseas business (trouble over the H-1B visa) and the depression in domestic tech spending, courtesy the overall economic downturn. If shares of some of these companies have gone up, then that is certainly not for speculative reasons.
There is also the issue of inflation slowly picking up. Higher inflation implies higher nominal GDP. This needs a higher level of money supply to support it. A lot of individuals are holding on to pure cash and putting it into bank deposit accounts. So, that explains a part of the liquidity uptake.
But overall, many — both individual investors and market analysts — have no explanation for the stock market going up the way it is, not with the kind of earnings that businesses have recorded in the preceding year and are likely to in the following year. So, now may not be the best time to buy stocks.
