Why is the stock market going up during a raging pandemic?
Finance
Image Source: Trading View
Sensex:
On March 23rd: Rs. 25,981
On August 21st: Rs 38,435
A rally of over 12000 points (48% increase) in 5 months during the times of Covid-19
Why is this worrying?
On one hand, we are in the midst of an economic crisis marked by subdued business activity and an increased unemployment rate (currently at a 9-week high of 9.1%). On the other hand, we have a stock market rally that refuses to abate.
Is this a bubble waiting to burst? Are we looking at another 2008-like recession in the making?
Not necessarily.
Reason 1: Initial Overreaction
Lets track back to a month before the markets started going up. Markets crashed 37% in 1 month. This could have been an overreaction due to panic selling with incoming news of the Coronavirus.
On Feb 20th: Rs. 41,170
On March 23rd: Rs. 25,981
Post this crash and lockdown imposition, the RBI stepped in and announced a INR 50k crore lifeline for Mutual Funds. This move eased liquidity pressure and boosted the confidence of investors.
Reason 2: Long-Term View
Unlike economic indicators, the Stock Market is forward-looking and looks at future cash flows for estimating valuation of stocks
Investors are optimistic about stimulus packages offered by the Government and potential vaccine breakthroughs
Having said that, an increase in stock prices without any improvement in fundamentals leads to stocks being overpriced. Let’s find out if they are.
While stock prices have increased, YoY earnings growth of most Sensex companies have gone down and the current Sensex P/E* ratio at 27** indicates that the market is certainly overvalued
This effectively means that one of two things must happen to restore fair valuations:
Company earnings must recover, or
There must be a correction in prices
*Price to Earnings Ratio — Price investors pay per rupee of earnings
**The P/E ratio before the stock market crash in 2008 was 28
Reason 3: Global Trends
The US and other Asian stock markets have a large bearing on the Indian Stock Market because of macroeconomic trends and herd mentality leading to similar trading patterns
Basis global trends, the Indian stock market rally is not an anomaly as Asian, European and US markets have seen a similar rally.
Reason 4: Skewed Indices
The rally in the US markets have been driven primarily by the FAANG* companies with large market capitalizations, which have benefited rather than been affected by the pandemic. Other US companies have not shown as much of an increase.
Similarly in the Sensex, the IT and pharmaceutical sectors and few stocks like Reliance Industries drove the rally forward, while the magnitude of increase was lesser in other stocks.
*FAANG — Facebook, Amazon, Apple, Netflix, Google
Reason 5: Retail Investors and Speculation
This rally, in many ways, is a retail-investor* fuelled rally as there has been a dramatic increase in retail participation since the beginning of this year, while the share of institutional investors** in market volume has declined in July.
As debt is no longer an attractive option due to low interest rates, there is a surge in first-time retail investors taking a shot at buying stocks
*Retail investors — Individuals/small financial entities
**Institutional investors — Investment banks/mutual funds/pension funds/foreign portfolio investors/hedge funds/private equity=
The risk here is that most retail investors have been involved in speculation (day trading) rather than value investing for the long term
A majority of their capital has been going into penny stocks and highly leveraged beaten down companies
If you’ve recently taken up trading and find your portfolio up in double digit percentages, it’s important to be wary of a potential nosedive in the market. Profit booking and value investing seem like artforms that are long lost but will determine the success of traders in near future. Either way, it’s exciting times for markets ahead!