India’s stock markets have taken a beating, the BSE Sensex having come down by more than 10,000 points from its peak last September. The broader market has fared worse, as the sharpest slide was in small-cap stocks, less severe in mid-caps and relatively modest among big companies.
While weakening market indices disappoint millions of investors, especially those who joined the action in recent years, this is not a disaster. It reflects neither a fundamental problem with our economy, nor any structural flaw in capital markets.
Rather, this correction represents the squeezing out of excess.
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Four factors had conspired to inflate equity prices: one, an influx of external liquidity arising from easy-money policies aimed at pandemic relief in the rich world; two, investor funds diverted to India by economic problems in China and some other emerging markets; three, euphoria over India’s growth prospects, stoked by last year’s election outcome; and four, a structural shift in the saving behaviour of our middle class, which swung away from the safety of bank deposits to embrace equities, either directly or via mutual funds.
The resultant deluge of money pushed stock prices way above levels justified by their price-earning multiples.
The first three elements of that combination have petered out and our stock market has sobered up. Is that such a bad thing? If we set aside the sentimental hope that stocks offer a one-way ticket to easy riches, this pullback is welcome. The function of capital markets is to allocate financial resources efficiently among various sectors. Inflated equity prices result in capital being misallocated.
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The excess we underwent is illustrated by the incident last August of a two-wheeler dealership’s ₹12-crore initial public offering (IPO) being showered with ₹4,800 crore worth of applications. When shares trade at sky-high multiples of annual earnings per share, it shows that people are buying them without looking at business prospects, but in the hope that a ‘greater fool’ would buy them at even higher prices, letting them make a quick buck.
Once this becomes a larger trend, companies find they can raise much more money than what’s warranted by their ability to generate value. In the process, money gets diverted away from businesses that may better deserve funds. Irrational exuberance, thus, gets in the way of what’s best for the economy. For funds to find their way to investment avenues that deploy it well, overpriced shares are a hindrance. We are better off with stock tickers going red if it expels the excess.
At what point will post-correction market prices be judged reasonable again? On average, the BSE’s LargeCap index may have reached that level, going by prices as a ratio of earnings, while its SmallCap index still looks too high and MidCap index less so. The important part is whether quick-buck investors have begun to view stocks the way they should—as investments with varied risk-return profiles, rather than mere casino-style punts.
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The worry is that some retail punters will be so put off by falling prices that they’ll opt for a clean exit from the market instead of focusing on what stocks are worth once asset inflation is reversed. There is no hard-and-fast valuation rule, but, by and large, share prices must go up in sync with profit potential.
To the extent such rationality drives the market, we have reason to be optimistic over where it is headed. But then, we cannot dismiss the odds of a tight bear hug either. Irrationality can go both ways too.
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