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The Reserve Bank of India (RBI) recently warned about a possible stock market bubble in its annual report for FY21. The central bank’s comment comes on the back of domestic stock markets touching record highs even as the country’s economy continues to face disruption due to the second wave of the Covid-19 pandemic.

Anyone who has followed the domestic stock market over the past few months will know that the bourses have been performing impressively, ignoring economic disruptions during the second wave.

Though a brief period of uncertainty was seen during the initial period of the second wave, benchmark indices S&P BSE Sensex and NSE Nifty50 have again started surging. On Friday, Nifty50 ended on a record high, while Sensex is inching ever closer to the 52,000-mark.

The strong market performance is a stark contrast to real economic growth, which has suffered due to localised lockdowns imposed by most states during the second wave. Many economic indicators have also taken a big knock during the second wave, though the situation is not as bad as the first wave.

So, the fact that there is a disconnect between the stock market and the real economy isn’t hard to establish. Should investors be worried? Here is all you need to know:

UNDERSTANDING STOCK MARKET BUBBLE

In the context of financial or economic markets, a bubble generally refers to a situation where the price of a stock, financial asset, an asset class or an entire sector exceeds the fundamental value by a significant margin.

Stock market bubbles are usually hard to predict, especially for those who do not track the market in-depth on a daily basis.

There are usually five stages to a financial or asset bubble and understanding each stage is essential to avoid wealth erosion. The five steps are displacement, boom, euphoria, profit-taking and panic.

Read | Explained: Why Indian stock market remains immune to 2nd Covid-19 wave

Simply put, the bubble is created on the basis of speculative optimism or demand, rather than the financial asset’s real or fundamental worth. When the bubble bursts, it leads to massive sell-offs and prices decline rapidly.

The housing bubble in 2008 that led to a severe global recession is one of the biggest examples, though there have been smaller instances in the past as well.

A stock market bubble usually involved inflated share prices that are often way higher than their company’s fundamental value including earnings and assets. The bubble can either involve the overall stock market, exchange-traded funds (ETFs) or shares in a particular sector.

IS THE STOCK MARKET IN A BUBBLE?

According to the Reserve Bank of India (RBI), prices of risky assets have surged across many countries and have touched record high levels during 2020-21 on the back of unparalleled levels of monetary and fiscal stimulus.

The central bank said the turn in market sentiments “following positive news on the development of and access to vaccines and the end of uncertainty surrounding US election results” were some of the major factors that led to increased valuation of global equities.

“The widening gap between stretched asset prices relative to prospects for recovery in real economic activity, however, emerged as a global policy concern,” RBI added.

It may be noted that during 2020-21, the BSE Sensex surged by 68 per cent to close at 49,509 while the Nifty 50 increased by 70.9 per cent to close at 14,691 on March 31, 2021.

India’s equity prices continued to surge, with the benchmark Sensex crossing 50,000 in January earlier this year. And on February 15, Sensex touched a peak of 52,154 — a 100.7 per cent increase from the slump just before the beginning of the nationwide lockdown on March 23, 2020.

RBI said, “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.”

While it is difficult to say whether the stock market is in a bubble at the moment, investors should note that inflated valuations are currently visible in stock markets across the globe. There are many other factors that also led to a rise in the valuation of domestic equity markets.

WHY INDIAN MARKETS ARE SURGING RAPIDLY?

The central bank highlighted that the amount of liquidity that has been injected to aid global economic recovery could have “unintended consequences” in form of inflationary asset prices.

“Providing a reason that liquidity support cannot be expected to be unrestrained and indefinite and may require calibrated unwinding once the pandemic waves are flattened and the real economy is firmly on recovery path,” the RBI said.

“Even considering the above expectations earning growth of the corporates, the stock prices cannot be explained by fundamentals alone. Present valuations, as in the past, are supported by improved corporate earnings. This part of Sensex increase can be seen as a rational trend,” the central bank added.

The RBI noted that the deviation of the actual price-to-earnings trends shows that the ratio is overvalued, while measures of dividend yield also signal that markets are getting “overpriced”.

While RBI has expressed concern about inflated stock market prices, the RBI also highlighted several other factors that have contributed to rising share prices including high FPI inflow. The equity market has received a net FPI inflow of Rs 2.8 lakh crore in 2020-21.

Another reason behind higher stock prices could be the sharp rise in direct participation of retail investors, with over 1.43 crore Demat accounts opened during 2020-21.

Besides increased activity, resource mobilisation through initial public offers (IPOs), follow-on public offers (FPOs) and rights issues increased by 43.1 per cent to Rs 1.1 lakh crore during 2020-21 from Rs 76,965 crore in the previous year.

Though the Reserve Bank of India has issued a fresh warning about a stock market bubble, it said future financial market movements would be guided by the progress made in containing the pandemic, the pace of recovery of global and domestic economies, and developments in global liquidity and financial conditions.

HOW WORRIED SHOULD INVESTORS BE?

At the moment, the Indian stock market seems to be rising rapidly after a period of hesitation during the second wave.

Though minor corrections can be expected throughout the year, depending on the evolving Covid-19 situation, market analysts are optimistic about the long-term performance of the domestic equity markets in India.

A recent report, based on a poll of analysts, suggested that Sensex will exceed the record high it hit in February by the end of this year. The poll of more than 30 equity analysts saw Sensex adding another five per cent and hitting a record of 53,200 by the end of 2021.

It may be noted that Sensex is forecast to rise over 54,000 by mid-2022, indicating that the stock market is likely to remain positive, unless it faces an unprecedented shock, which could break the positive momentum and lower sentiment

CA Rudramurthy, director at Vachana Investments, told the news agency that the equity market always discounts what today’s fundamentals are and instead looks at what it might be for the three to six months down the line.

“But trading will be more selective this year than in 2020, when it was more speculative and you could buy any stock and prices just kept rising – that bit is done,” Rudramurthy added.

Most analysts who participated in the poll feel that the risk to the Indian stock market from the second Covid-19 wave is low.

“All the bad news from the Covid-19 second wave is done and dusted and is already discounted in stock prices. Even if the expected third wave hits, it wouldn’t be a new situation,” Rudramurthy said.