The unprecedented rise in the stock indices fails to correlate with the economic situation of the world. In India, people are still reeling from the aftermath of the second wave of the COVID-19 pandemic. One would expect markets to be bearish at this time, especially given the 7.3% contraction in the GDP in 2020-21. However, Sensex gained 3,200 points in May 2021 only, at a time where business activities had come to a standstill due to the lockdowns imposed across the country. In the absence of positive economic indicators, these signs stipulate the existence of a bubble in the stock market.
What is a stock market bubble?
Simply put, it is an economic phenomenon that occurs when the share prices of companies drastically rise, without a proportionate increase in their fundamental value (assets, profitability, turnover). Herd mentality and a fear of missing out on lucrative profit opportunities, spurring a confirmation bias in people are primary causes attributed to market bubbles. These bubbles occur in isolation to the business environment, without taking into consideration the economic, political or market conditions. A telling sign for a bubble is an abnormally high price-equity ratio, which shows that the markets are running overpriced. In May, the Sensex was trading at a ratio of 32, as compared to the usual 23.
These bubbles are characterized by frenzied IPO markets, where investments are dictated by speculation rather than a stable rate of return. They can be restricted to equities of a particular sector, exchange-traded funds, or the entire stock market. These bubbles often burst, drastically reducing the share prices and nullifying the value of investments, leaving millions of investors in the lurch; the extent of damage caused depends on the nature of the sector involved and its participants. One of the lesser-known equity bubbles was the one in 1992 Japan, which stagnated their economy to an extent that the period is now known as the Lost Decade. These bubbles can derail the global economic order – the one in the American stock market in the 1920s led to the Wall Street Crash in 1929, followed by the period of the Great Depression for the world.
What is the current situation?
Increasing demand for unstable investments like Bitcoin and Dogecoin, and the highly speculative securities of Tesla and GameStop have created the current bubble in stock markets across countries. This curious economic trend is spurred by groupthink prevailing amongst retail investors through social media platforms, with meme stocks (stocks that experience a price surge due to their hype on social media) like AMC Entertainment, Virgin Galactic and Palantir being the largest gainers. It has an uncanny resemblance to the Dot-com bubble of the 1990s, which was due to the speculative activities around the emergence of innovative technologies like the Internet and e-commerce. Willy Packer of Packer & Co has summarised the situation succinctly- “It’s like we’re all on the Titanic and everyone’s having a drink on the top deck.”
The Reserve Bank of India (RBI) shares the same concerns as that of Mr Packer, and other top investors like Timothy Burch, Michael Burry and Jeremy Grantham. Its annual report for FY21 commented on the record highs of Indian stock markets, spurred by unparalleled levels of monetary and fiscal stimulus which spur the bullish investors. In their statement, the central bank stated that improved corporate earnings only explain a part of the increase in the Sensex and Nifty, both of which are at an all-time high. Despite these warnings, Sensex is forecasted to rise over 54,000 in 2022, indicating that stock markets might retain their momentum. Low interest rates for debt instruments have led to people opting into equity holdings even more, with retail investors massively benefiting from better returns than those who invested in bank deposits.
What happens next?
Bubbles do not always burst and cause huge ramifications, especially if investors and institutions take corrective action at the right time. Professionals are urging participants to stick to basic tenets of investing- diversification, asset allocation and rebalancing of portfolios. Retail investors are advised to maintain investments according to their equity allocation and scale down to the planned ratio if needed. Moreover, smart investments into companies with strong fundamentals are the need of the hour, which can allow investors to weather out the 10-15% expected correction in the near future and bolster their long-term growth.
Out of the five phases of a typical bubble- displacement, boom, euphoria, profit-taking, and panic, it is clear that we are well into the euphoria phase. There is confirmation bias about new valuation metrics, which provide a positive outlook of the situation. The “greater fool” theory – stating that no matter how much the prices rise, buyers will always be willing to pay more – is prevalent in the status quo. Everyone who has skin in the game is waiting for the other shoe to drop – a small prick in the proverbial bubble, which would awaken people from their stupor and necessitate mitigating action.