Should I stop investments since RBI has declared risk of stock market bubble

Published: May 31, 2021 at 7:13 am

Last Updated on May 31, 2021 at 7:13 am

On May 27th 2020, the Reserve Bank of India released its annual report for 2020-2021.  On page 93 (II. Economic Review), a section titled, “Is the Bubble in Stock Markets Rational?” caught the eye of the financial media. Over the last couple of days, we have received several emails and comments from worried investors regarding this report. Some want to delay lump sum investments. Some want to stop all investments. Does this make any sense? A discussion.

So what did the RBI say? They estimate an 8% contraction in the GDP in 2020-21, and the 100% increase in the benchmark index is irrational and seems like a bubble. Here is the extract from the report.

“India’s equity prices also surged to record highs, with the benchmark index (Sensex) crossing the 50,000 mark on January 21, 2021, to touch a peak of 52,154 on February 15, 2021, which represents a 100.7 per cent increase from the slump just before the beginning of the nationwide lockdown (i.e., since March 23, 2020) and a 68.0 per cent increase over the year 2020-21. 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.”

They go on to cite some research on what governs stock market prices and add, “stock price index is mainly driven by money supply and FPI investments. Economic prospects also contribute to movement in the stock market, but the impact is relatively less compared to money supply and FPI.”

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The markets surprised everyone with a 90-100% surge post the crash. However, there has been a noticeable slowdown in 2021. One does not need to be an expert or a soothsayer to expect the returns from March 2021 to Feb 2022 to be much lower than what it was one year earlier. FY 2021-22 returns are also likely to be lower than the 68% seen in the previous FY.

This does not mean the stock market will come crashing down because investors are worried about the GDP contraction. The situation is quite similar to what happened in the US markets after the 2008 crash, as explained by portfolio manager Ben Felix in this excellent video.

It is quite possible the markets have already priced in the lower GDP growth rate and expected worse. As explained in the above video, there is little connection between stock market returns and economic data over the short term. One cannot (should not) make investment decisions based on this.

Ben refers to a paper by Jay Ritter, Is Economic Growth Good for Investors? that shows that even over the long term, there is no correlation between economic growth and stock returns! In fact, there was a negative correlation between per capita economic growth and equity returns for both developed and developed countries!

So the next time a mutual fund sales guy talks about 12% or 15% returns from equity mutual funds because of the “Indian Growth story” and “GDP growth”, please disregard it. Also, see: the 42-year return of Sensex and S&P 500 (INR) is the same!

A lower GDP growth rate is hardly a surprise to bring the markets down. Most investors would have expected it. The market has already started to “wait” for corporate earnings to catch up. For the markets to crash, something unexpected should happen.

At the time of writing, what seems more likely is several months of muted returns. If your goals are several years away, there cannot be a better time to invest. We cannot expect the market to give spectacular returns each year, but that is anyway the case RBI report or no report, the market at an all-time high or not.

If indeed the market goes nowhere for months or years to come, this is the best time to accumulate stocks or mutual fund units (subject to the requirement of your goals).

We have already shown that whether you invest each month or have a lump sum to deploy “all-time highs” are quite irrelevant to what happens over the long term: Should I stop my mutual fund SIPs when the market is at an all-time high?

Delaying investing just because the market Is high or because we fear a crash is one of the worst mistakes we can make with our money. We can wait, we can run, but there is no hiding from bad returns from a period of no returns. It is inevitable. It is better to embrace it and build a goal-based investment and de-risking plan that will work despite the poor returns.

In summary, there is no one to one correspondence between GDP growth and stock market returns. Therefore we recommend that investors continue investing systematically with an asset allocation plan suitable for their goals. Those with a lump sum can invest in small chunks over the next few weeks or months as per their comfort level. Also, see: Investing a lump sum in one-shot vs gradually (STP) in an equity mutual fund (backtest results).

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