The stock market bubble: Bubbles burst, invest carefully

In the 2015 film Big Short, a film about the 2008 financial crisis, there is the profound line which goes like this- "No one can see a bubble. That's what makes it a bubble." But there is only one thing that happens to bubbles, they burst and this time, the bubble seems bigger.

With the Sensex touching 35,800 and Nifty getting within kissing distance of 11,000, the bulls seems to have the bears caged. The question is when are bears going to get up and make their play? If the bears do come to dominate, how much would it cost the average middle-class Indian who has been led into believing that the stock market is a safe place where everyone makes money and the markets are going to he headed in only one direction, up.

The last 13 months since demonetisation have been nothing short of a dream run from the Indian stock markets. The Sensex stood at 27,591 points on November 8, 2016 and is up by nearly 30 per cent since then. The Nifty too has gone up by 28% from 8,543, the day demonetisation was announced. 28-30 per cent jump in stock market indices over a year has come at a time when the fundamentals of the economy have been disrupted, first by demonetisation and then by the hasty implementation of the GST.

Seasoned investors are a divided house these days. Those who play by the sentiment are going all out to make money while the sun is shining, the ones who play on the fundamentals are wondering what happens next. The bull run has already gone on for too long and they have simply given up keep track of the technical pointers.

The biggest concern for them, is that both profit to equity ratio and the price to book ratio have reached levels where it has stopped making any sense. The Nifty PE ratio to 27.62 while the Price to Book ratio has crossed 3.7, indicating that the stocks are massively overvalued for those who play by the fundamentals book. To put the numbers in perspective, the price to equity ratio for Nifty was at 22.57 on November 8, 2016, indicating that the markets have gone up mainly on emotion, not on reason.

But it would be important to look at what is happening in the background to really understand what is causing the rally. Since demonetisation was announced in November, Domestic Institutional Investors (DIIs) have been pumping money at unprecedented speed. DIIs have put in a massive ₹118,899 crore in the markets since November 2016 while the Foreign Institutional Investors have pulled out a massive Rs 70,408 crore from the markets.

To put the numbers in perspective, in the 14 months preceding demonetization, DIIs had invested Rs 31531 crore in the stock market, against ₹1,083 crore by the FIIs. What these numbers tell us is a very interesting story, DIIs are now investing about four times the money they invested before demonetization.

The stock market boom has come at a time when the real estate market is sitting on an unsold inventory of 6.85 lakh units at the end of the September 2017. Gold, on the other hand, has appreciated by little over 3 per cent over the last year, barely above inflation levels. With stock market giving 10 times the returns as gold, investors are making a beeline for the stock markets, pushing it into levels which were unexplainable from any technical standpoint.

Like the stock market valuations, the Sensex PE ratio of 26.03 is also at its record highs. In January 2008, the Sensex hit a high of 20,728 points with the PE ratio of 25.53. That started a massive correction and took the markets to 9,000 points in March 2009, brining the PE ratios down to 12.68. The Sensex touched 21,000 in November 2010 and this time the peak PE ratio was around 23, the market lost another 5,500 points over the next one month.

The bulls are drawing some strength from the opening of the earnings season but only little over a hundred companies have reported their quarterly numbers so far. It would be unfair to expect that the new profit numbers would bring down the PE ratios substantially. Besides, there is serious macro-economic trouble on the horizon.

The market has been due for a major correction for a substantial period of time, in the meantime, the markets continue to go up and the FIIs too seem to join the party. Like a game of musical chairs, the game starts when the music stops. There is an old saying in the financial markets, the bulls make money, the bears make money, the pigs get slaughtered. Invest carefully.