Speculation and Indian Stock Market – Arthvigyan

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Recently we came across this wonderful book stock market bubble – Dot.con by John Cassidy. The book has beautifully explained how bubbles are formed, how actions from policy makers affect the stock price, what are the factors which keep bubble for long period of time, what are the factors which lead to burst of bubble, etc.

Taking the base of learnings from the book, we have tried to form a perspective on current Indian stock market boom.

What is Speculation and stages of speculation?

According to the McGraw-Hill Dictionary of Modern Economics, Speculation is “the act of knowingly assuming above-average risks with the hope of gaining above-average returns on a business or financial transaction.”

There is no settled definition of a speculative bubble. Like pornography, it is easier to spot one than to define it. Broadly speaking, if the price of an asset—a stock, a house, a gold ring, or any other item of value—rises beyond anything that can be justified on economic grounds, and then keeps on rising for an extended period, it is a speculative bubble.

Four stages of Speculation

1. Displacement starts when something like a shift in government policy, a discovery, a fabulous new invention, etc. changes people’s expectations about the future (Early investor’s make huge money)

2. Boom Stage is when prices are rising sharply and scepticism gives way to greed. The sight of easy money being made lures people into the market, which keeps rising prices further rise, which, in turn, attracts more investors

3. Euphoria – Established rules of investing, and often mere common sense, are dispensed with. Prices lose all connection with reality. Investors know this situation can’t last forever, and they vie to cash in before the bubble bursts.

4. Bust – Sometimes there is clear reason for the break and sometimes the market implodes of its own accord. Either way, prices plummet, speculators and companies go bankrupt, and the economy heads into recession.

Current Stock Market Environment

Currently, Sensex (49,035 as at 15th Jan 21) is trading at PE of 26 way above last 21 year’s average PE of 19. Many investors are suggesting that we are in bubble territory. There are few reasons why Sensex is trading at such high multiples

  1. Low interest rate (RBI reduced Repo rate from 5.15% to 4%. In addition to that interest rate in most of developed economies are hovering below 1%
  2. Gush of liquidity all around the world. (FII investment in India is at USD 33 Billion – highest as compared to last 20 years)
  3. Though there is contraction in GDP growth all over the world, there are few sectors like Technology, Healthcare, Online gaming, OTT etc. which are beneficiary of pandemic. In Indian context few other sectors got benefited due to geo-political factor and government actions like Chemicals (China + 1 policy), manufacturing, Pharma. Also Indian rural sector has shown resilience as it was not affected from lockdown (esp. Agriculture – The same can be seen in growth in Tractor sales).
  4. Supportive policy action from government all over world. (Government stimulus as a % of GDP ranges from 10% to 20%)
  5. High participation from retail investors

All of these factors have contributed to rise in Sensex, even when most of the economist are talking about disconnect between stock prices and economic reality (severe contraction in GDP growth, informal sector is hit in big way which is not captured in GDP, destruction of small business, etc.).

How long will this disparity in economic reality and stock price will go on?

This can be explained with George Soros’s, billionaire investor, Theory of Reflectivity:

  •  In a bull market, Soros argued, the very fact that stock prices are rising appears to improve the economic outlook, which prompts investors to become even more optimistic. This leads to more buying, and the market rises further, thus restarting the cycle. Soros used the word “reflexivity” to describe this self-reinforcing process.
  •  With each oscillation of the cycle, investor’s expectations about future profits and economic growth ratchet upward. Eventually, their expectations move so out of line with reality that they are impossible to fulfil.
  •  At this point, the market becomes vulnerable to a correction. Disappointed expectations have a negative effect on stock prices, and falling stock prices make the economic fundamentals look worse. Unless more good news arrive quickly, reflexivity starts to work in the opposite direction. The drop in stock prices feeds on itself, eventually leading to a collapse.

As per this theory, as long as positive news are coming, stock prices will keep rising.

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What should investor do in this kind of environment?

 When investors see the stock prices rising high day after day and are faced with a choice of actions, such as deciding whether to buy Tesla or info edge or Dixon at a price equal to several hundred times its revenues, a person can respond to the rising market in one of two ways:

  • First option is to rely on the information of others and imitate the actions of others. As an evolutionary process for survival, we have learnt to imitate actions of others to take advantage of the hard-won information of others. Once a few people decide to rely on others rather than thinking for themselves, the behaviour can quickly spread. If this happens, the result may be an “informational cascade in which, ultimately, nobody acts on his or her own judgment. 

   Reflexivity can keep stock market rising for a long period of time. If one wants to ride     this bull ride one can participate in it, however, one should be clear that such bets         would be speculative and can be very risky as they are not clearly linked with      fundamentals.

  • Second option is to examine all of the alternatives, weigh up their costs and benefits, and make an independent judgment. Investors can take independent view on a company’s earning potential and runway of growth. If an investor concludes that a company is at inflexion point and can compound at rate far higher than earlier growth rate under normal environment, he/she should bet big on the company even though optically it is trading at high valuation. But he/she should not overpay for growth.

Conclusion:

Considering above factors, we believe that we are in between boom stage and euphoria stage in few sectors like technology (may not be traditional IT companies), manufacturing, etc. Investor should remember below quote of Warren Buffet – “You’re dealing with a lot of silly people in the marketplace; it’s like a casino and everyone else is boozing. If you can stick with Pepsi, you should be O.K.



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Vivek Chitale

Vivek Chitale

Life long learner | Passionate about investing in the stock market | Trying to bring differential insights
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