Measures of dividend yield also signal that markets are getting overpriced
The RBI’s concern over the relentless increase in stock prices without fundamental backing could lead to a bubble in the stock market.
The asset price inflation in the context of the estimated 8 per cent contraction in GDP in 2020-21 poses the risk of a bubble, it added.
Money supply, FPIs
The stock price index was driven mainly by money supply and foreign portfolio investor investments. Economic prospects also contributed to stock price movement, but the impact was relatively less compared to money supply and FPI.
This assessment shows that the liquidity injected to support economic recovery can lead to unintended consequences in the form of inflationary asset prices. It may require calibrated unwinding once the pandemic waves are flattened and the real economy is on the recovery path, it said.
Even considering the above expectations and the earnings growth of the corporates, the stock prices cannot be explained by fundamentals alone, said the report. The deviation of the actual price-to-equity ratio from its long-term trend shows that the ratio is overvalued. Measures of dividend yield also signal that markets are getting overpriced, it added.
A decomposition of changes in equity prices indicates that the rise in equity prices from 2016 to early last year was mainly supported by fall in interest rates and equity risk premium (ERP), with increase in forward earnings expectations contributing to a lesser extent. Thereafter, a spike in ERP on Covid concerns initially pulled down equity prices sharply to compensate for increased risks.
An impressive recovery
However, equity prices registered an impressive recovery, aided by easing of ERP. Currently, dividend yields have fallen below their long-term trends. As such, two-way price movements are possible going forward, said RBI.
Vinod Nair, Head of Research, Geojit Financial Services, said the central bank’s warning of the risk of a bubble in the equity market has made the market cautious. The RBI has noted a disconnect between the market and economy due to Covid. The equity market is valued based on its future earnings growth proposition, which is solid for India today. High liquidity does help the market and RBI has reaffirmed its supportive stance till the economy recovers, he added.