The disconnect between the real economy and the stock market continues to grow with the Nifty50
index rising to new peaks even as economic projections remain grim. The Nifty scaled the heights of 13,000-plus this week despite a growing consensus that while the pace of economic contraction will improve, India would be among the worst affected of the world’s large economies. Economic observers also say that the economy will be back to the pre-Covid levels not before the latter half of 2021-22. The dip in various macro-economic indicators in November has already led agencies such as ICRA to conclude that the spikes in production seen in various sectors in October are an exaggeration of a true recovery on the ground, as they have been driven by a large component of pent-up demand that may not sustain after the festive period is over. But valuations are at record levels with PE (price/earnings) of 35 for the Nifty, and even higher for midcaps and smallcaps, although the earnings trend is expected to be negative.
Nevertheless, equity investors, especially the foreign portfolio investors (FPI), have pumped in huge sums into the Indian stock markets, making India among the best performers in a global equity rally. The FPIs have invested Rs 58,690 crore in November (so far) in Indian equities, and a net Rs 1.54 trillion in the current fiscal year, while pulling Rs 37,362 crore out of rupee debt. The rupee has strengthened on the basis of big FPI inflows. The Indian institutions have sold nearly Rs 40,000 crore in November while mutual funds have seen net inflows of about Rs 3,000 crore into equity schemes between April and October. However, fund managers have reduced their cash holdings, which indicates at least some of the smart Indian money is moving into equity.
What explains this divergence between the depressing fundamentals and an optimistic investor attitude? Many investors are adjusting to the likelihood that the upcoming Biden administration in the US will be less capricious in its geopolitical stance. Another reason for this optimism is the visibility of vaccines that could end the pandemic. However, immunising India’s population will be a vast exercise and will take around a year before herd immunity is created. Part of the rally is explained by low returns from debt. Rupee debt and government paper are yielding negative real returns, with inflation above prevailing interest rates. The Reserve Bank of India’s determination to maintain easy money supply and keep policy rates low until such time as there is an economic recovery, also means investors don’t expect debt returns to improve in the medium term. Hence, there is a greater incentive to brave the risks of the stock market.
Beyond this, some long-term investors are betting on a faster than expected recovery in corporate performance, while others are playing the momentum game. Algorithmic volumes have risen on the National Stock Exchange in the past three months. This suggests that the “quants” are big participants. That should be a red flag since speculative quant positions can be dissolved as fast as they can be created. It is a truism that equity always gives the best long-term returns. But this movement, which appears unsupported by the fundamentals, is likely to see a breakdown. Equity investors should be prepared for a pattern of increasing volatility, and also for deep corrections if there is further bad news on any front.