The Reserve Bank of India (RBI) sees a bubble building in the stock market as prices of risky assets surged across countries to record high levels during the year. The benchmark Sensex is just about 1,000 points away from its all-time high hit on February 16. It has risen a whopping 100 per cent from the slump witnessed in March 2020 after Covid-19 lockdown. The gains, RBI believes, have come on the back of unparalleled levels of monetary and fiscal stimulus, positive news around vaccination and the end of uncertainty surrounding US election results.
"The widening gap between stretched asset prices relative to prospects for recovery in real economic activity, however, emerged as a global policy concern," the Central Bank noted in its annual report 2020-21.
"This order of asset price inflation in the context of the estimated 8 per cent contraction in GDP in 2020-21 poses the risk of a bubble," it says.
The RBI further highlighted that stock price index is mainly driven by money supply and FPI investments.
"Economic prospects also contribute to movement in the stock market, but the impact is relatively less compared to money supply and FPI. This assessment shows that liquidity injected to support economic recovery can lead to unintended consequences in the form of inflationary asset prices and providing a reason that liquidity support cannot be expected to be unrestrained and indefinite and may require calibrated unwinding once the pandemic waves are flattened and real economy is firmly on recovery path," the report says.
Comparing the price-to-earnings (P/E) ratio with its historical trend, the RBI sees overstretched valuations. However, dividend yields indicate two-way price movements are likely.
"The deviation of the actual P/E from its long-run trend shows that the ratio is overvalued. Measures of dividend yield also signal that markets are getting overpriced," says RBI.
The central bank suggested that the rise in equity prices during 2016 to early 2020 was mainly supported by a decrease in interest rates and Equity Risk Premium (ERP), with an increase in forward earnings expectations contributing to a lesser extent.
"Thereafter, a spike in ERP on COVID-19 concerns initially contributed to equity prices declining sharply to compensate for increased risks. However, equity prices registered an impressive recovery, subsequently, aided by easing of ERP. Currently, dividend yields have fallen below their long-term trends. As such, two-way price movements are possible going forward," it explained.
What should you do?
Marketmen agree with the RBI's 'bubble' theory. They see a correction likely at the current levels.
"Real interest rates have turned negative in the US which is an early signal for a correction in the stock market. In addition, our overextended valuation and slump in demand in few sectors due to the resurgence of COVID in Apr-May 2021, indicates that our stock market is definitely in a bubble. So, we would recommend investors hold their position only in quality stocks and update stop-loss levels on momentum," says Vinit Bolinjkar, head of research, Ventura Securities.
"Don't chase stocks and only buy fundamentally sound stocks at the right valuation and at the right price. We believe that only quality businesses are expected to outperform in case of the market crash and do well in future," he adds.