RBI’s annual report warns of the risks of a bubble in equity markets 

The divergence between soaring stock markets and a faltering economy has attracted widespread attention. Several pundits have opined about the reasons. The Reserve Bank of India, in its annual report, has now waded into the discussion. The heading of one of the boxes in the annual report asks the question: ‘Is the Bubble in Stock Markets rational?’

At the outset, it’s worth noting that the framing of the question suggests that the central bank believes that the equity markets are indeed in a bubble.

The report looks at the widening gap between stretched asset prices relative to the weak real economy. Taking into account the steep rise in the Indian equity markets, the central bank says, ‘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.’

The RBI has also developed a model to find out what has driven the stock index higher. It does so ‘by regressing stock prices (Sensex) on money supply (M3, as a proxy of liquidity), the economic outlook (OECD composite lead indicator - CLI) and foreign portfolio investments in the secondary equity market for the period April 2005 to December 2020.’

The results of that statistical exercise show that the stock price index is mainly driven by money supply and foreign portfolio investment. While economic prospects are also a factor, its impact is less than that of the other two.

The report agrees that improved corporate earnings also lead to higher stock prices and says that the part of the increase in the index on account of this factor is rational. But it also says that the current rise in equity prices cannot be explained by the fundamentals alone.

The RBI has studied the increase in the stock index from 2016 to early 2020 and it says this was mainly supported by a decrease in interest rates and the equity risk premium (ERP), while the contribution of the increase in forward earnings expectations was lower. (The equity risk premium is the excess return earned by an investor when they invest in the stock market over the risk-free rate. It’s a measure of the compensation for the higher risk of investing in equities.)

After the plunge in March last year due to the COVID-19 outbreak, the report says, ‘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.’ Stock markets always have two-way price movements, so perhaps it’s the central bank’s way of drawing attention to the heightened risk in the market. It could also mean that the more or less steady rise in the stock index could easily reverse.

The report clearly says that the equity markets are overvalued on several parameters. It warns that the deviation of the actual price-earnings multiple from its long-run trend shows that the yardstick is overvalued. It adds that measures of dividend yield also signal that markets are getting overpriced.

The report says that the liquidity injected to support the economic recovery can lead to unintended consequences in the form of inflationary asset prices. That is why it says, ‘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.’