Pandemic surge: Why is the stock market so far removed from current economic realities, asks A L I Chougule

The second Covid wave hit us very hard. But the good thing is that just as quickly as it had risen, it seems to be ebbing. While India is only just coming out of its impact, there is a fear of a third wave coming in a couple of months. The economy is likely to take another hit as a result of state-level lockdowns, which will impact business earnings. Two waves of Covid-19 in less than two years, have crippled lives and livelihoods.

The economic condition of the people, which was already impacted by a slowdown in GDP growth even before the pandemic arrived, has further worsened because of coronavirus which has affected everything from jobs to businesses. The double whammy has pushed back demand to the levels of a few years ago. Combine that with low consumer confidence, rising commodity prices and rising inflation concerns and you have a potent combination for lower economic growth.

Record bull runs

But the stock markets, on the other hand, are booming, as if in complete disregard to the impact of the second Covid wave. In fact, recently, both the Sensex and Nifty hit all-time highs and chances are the Sensex may hit the 53,000-levels, while the Nifty looks set to touch 16,000 points in coming weeks. Why are the markets rising the way they are, when the bruised country, as also the economy, is barely recovering from the second Covid wave?

While generally, markets are linked to economic growth over a longer period of 10 to 20 years, the same cannot be said about the short to medium term. In fact, in the last one year there has been no linkage between the economy and market movement. The same is true about the market movement since the middle of May: the Sensex has risen at least 8 percent. So, what explains the divergence between markets and economic conditions?

The robustness of the markets, according to experts, can be explained by the fact that equity markets are always forward-looking in nature. The fact that the second Covid wave did hit us hard but is also ebbing fast could lead to a faster economic recovery. Market players are of the view that while the human impact of the second wave was devastating, its economic impact would be limited, given that there was no national lockdown but only regional lockdowns, resulting in less disruption to economic activity. While it seems a good enough reason that may have prevented a sharp correction, it however, does not justify lifetime highs for markets in the midst of a pandemic.

Just like in 1918

But then that’s precisely what happened last year too, which took many by surprise: after an initial sharp knee-jerk reaction that barely lasted a few weeks, the markets witnessed a V-shaped recovery to usher in a bull market, in spite of the pandemic and despite moderate fiscal support.

According to moneycontrol.com research, a business and finance news website, something similar happened during and the only comparable pandemic of the last century, the Spanish flu of 1918-19: markets were largely steady, with an upward bias during the period of the flu’s three phases, the second wave being the worst, similar to what we are witnessing now. One of the reasons for absence of upheavals in the markets then was said to be the end of the World War I. This time around, it is said to be the interventions by governments and central banks early in the crisis and subsequently, the rally got a shot in the arm from the visibility of a vaccine.

While all this holds for global markets, things look far too stretched for Indian markets, given that the second wave has affected both lives and livelihoods. Apparently, despite soaring commodity prices, there appears to be a fair degree of optimism. These hopes are riding on a relatively sharp but shorter second wave of the pandemic on expectations of a wider coverage of vaccination in the country.

Fear of missing out

So, what’s supporting the markets when the economy is in a bad shape? Apparently, investors do not want to be left out of the recovery rally this time around and are hoping for a better second half of the current financial year. Markets and investors are also willing to live with a muted FY22, hoping for a lot of catching up in FY23. Also, markets are hoping that corporate earnings could be better, just as was the case last year when businesses reported better results on account of soft input prices and adept cost management.

But given that there is a demand problem in the economy, rising inflationary pressure and soaring commodity prices could squeeze operating margins and hurt the profitability of businesses. While market players acknowledge the challenges to short term growth and profitability and are bracing for a bumpy ride in the first half of the current fiscal, they are, however, hoping for better corporate profits in the second half.

More than earnings, it is the liquidity – both domestic and foreign – that seems to be lending support to the markets. Foreign portfolio investors (FPI) were aggressive buyers of Indian equities in the second half of FY21. They are expected to continue with their positive outlook on Indian equities over a longer term, even if they turn neutral for a shorter period. What is also supporting the markets is the RBI’s accommodative policy to support growth, as also the expectations of a fiscal stimulus to the economy, which could push FY22 GDP growth higher than expected. The market is currently trading at a price-to-earnings ratio of 32, which is a clear sign of an overpriced market.

RBI concerns

Even the RBI, in its annual report recently, had flagged concerns about the high valuations in the market, which are far from ground realities and also hinted that the Indian equity markets are in a bubble. The surge in the stock market prices, the RBI has attributed to the liquidity infused to support the economic recovery and FPI investments.

This has been the case since 2016, as the RBI annual report has noted, mainly because of decrease in interest rates and equity risk premium, with increase in forward earnings expectations contributing to a lesser extent. Though markets are slaves to earnings, earnings have lagged behind considerably while the market has surged significantly since 2014, on the back of easy liquidity and lack of alternative investment options.

For instance, according to the RBI analysis of equity returns data of last 15 years, between 2006 and 2013, Nifty returns at 10.5 per cent closely tracked the Nifty annualised earnings growth of 10.4 per cent. However, this correlation was completely broken from 2014 to 2020: annualised Nifty earnings growth of 2.6 per cent was way behind annualised Nifty returns of 12 per cent. This clearly suggests that liquidity support has had a greater bearing on equity prices, compared to economic prospects. It’s not surprising then that the stock market is not reflecting the current economic realities.

The author is an independent senior journalist

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