DAX readings at the stock exchange in Frankfurt. (Reuters)

Markets around the world have surged since end-March, seemingly oblivious to the pandemic. The NASDAQ Composite has hit new lifetime highs, Dow and DAX have registered over 50% gains since March, and Brazil’s Bovespa Index hit a more than four-month high this month. The Sensex has gained over 40% since hitting a low of 25,981 on March 23 – and continues to rise even as daily case numbers have gone from around 9,000 in the first week of June to 40,000-45,000 now.

Signs of a bubble?

Financial asset bubbles typically build up when the surge in financial market indices fail to reflect the underlying valuations of the asset class for an extended period. The primary reason why markets are rallying is the mega stimulus packages announced by global central banks. The US rally started at the same time when the decks were cleared for the most expensive bailout in US history. Three weeks later, the Federal Reserve announced it would inject another $2.3 trillion through unprecedented emergency initiatives targeted at small and midsize businesses, and state and municipal governments.

With the Fed starting to buy up government debt and undertaking to purchase private assets – including the corporate debt of companies such as AT&T, Tesla, Apple and Coca-Cola – while also lending directly to a range of market participants, share and bond prices have soared. Most companies tried to get over the slide in revenues by attempting to raise fresh capital, both by selling shares and issuing new bonds. Globally, nearly $5.5 trillion is estimated to have been raised so far this year. This has triggered a windfall on Wall Street, and a cascading rally across other bourses.

What’s the problem?

The stimulus may have juiced the market recovery since April, but analysts say the S&P 500 — an index that measures the stock performance of 500 large companies, and is one of the best representations of US stock markets — has underlying weaknesses: unrealistic valuation multiples and overleveraged corporate balance sheets.

Another major distortion triggered by the Fed’s intervention is that stocks and bonds are now moving in tandem, which does not typically happen. The Fed will deliver an update on interest rate policy and the economy on Wednesday.

There is a growing view that the rally could crash once it runs out of the fuel of fiscal and monetary policy support. There are signs of distress already: trading volumes in American bourses have dipped, and there are indications that big businesses, already saturated, will not need so much new money. Another significant signal is coming up — the boosted employment provision under the CARES Act will expire on July 31. While Congress is discussing the second stimulus, reports suggest it’s unlikely to come through by July 31.

The US Fed and Treasury have together backstopped over 10% of America’s entire stock of business debt during this period, but all this could change once the government stimulus tapers off. The largest American banks have stashed away over $50 billion to prepare for the fallout. “We are in a completely unpredictable environment… The pandemic has a grip on the economy, and it doesn’t seem likely to loosen until vaccines are widely available,” Citigroup CEO Michael Corbat said earlier this month.

Kevin Smith, founder of the hedge fund Crescat Capital, has predicted that the Dow and S&P 500 are on the verge of a Great Depression-level crash. Smith has repeatedly said that the stock market trend now is similar to the 1930 “relief rally” in the wake of the ‘Black Monday’ crash. During that crash, stocks fell 45% in mid-1929 — but a near 50% rally followed from late 1929 until March 1930. After that, stocks fell more than 80%, and the unprecedented bear market ultimately wiped nearly 90% off the Dow.

Situation in Indian markets

A US crash could have a cascading impact, and India could be caught in the maelstrom on account of both the slide in the US and intrinsic issues relating to the fundamentals of Indian markets. Both BSE and NSE have rebounded about 43% since crashing to a four-year low in March as huge flows of cheap capital provided by central banks have turned heavily-discounted stocks attractive. At present, though, the Sensex earnings multiplier of over 24, and Price/Book multiple of nearly 3 are uncomfortably high — and a widespread sell-off is a distinct possibility, analysts say.

(Earnings multiplier pegs a company’s current stock price in terms of the earnings per share, and provides an idea of whether it is overly expensive. P/B is the ratio of a firm’s market capitalisation to its tangible asset value; ratios of under 1 are typically considered to be solid investments.)

Given that companies won’t see a sharp increase in their earnings, the vulnerabilities in the Sensex valuations appear all too obvious. Early bird results for the June 2020 quarter point to a slightly better-than-expected showing by India Inc, helped largely by a good showing by IT companies, financial services, and PSUs. The combined gross profit of the 90-odd companies that have declared results was down nearly 10% year on year, while net profit and toplines were down about 3.5% in the April-June quarter. However, these numbers are likely to worsen as more companies announce results.

Also, in India, much of the government’s relief package has been liquidity driven, focused on pushing banks to extend credit on the back of government guarantees to small businesses, non-banking financial companies, microfinance institutions, and housing finance companies. Over the last three months, RBI has cut its key policy rate by 115 basis points, and announced a liquidity injection of around Rs 8 lakh crore in the financial markets since its first announcement on March 27. Market analysts say that with so much liquidity worldwide and very few places for it to go, much of the money is finding its way into stock markets.

Another concern is non-performing assets for banks, which may begin to show up after the moratorium period ends on August 31. An MSME distress funding scheme is open until October 31. Once end-by dates are reached, a shock could follow.

Foreign portfolio investment (FPI) inflows have jumped after the record net outflows of nearly Rs 62,000 crore in March 2020. In May and June, FPIs have invested a net Rs 36,400 crore in Indian equities. There has also been a sharp jump in the market share of non-institutional (retail) investors in the cash segment — the highest since August 2009.
In the medium term, the fundamental risks to the global economy look like increasing, with the pandemic nowhere near ending. FY21 is a washout in terms of earnings, and this distress will start getting reflected in market valuations soon. There are also red flags in fresh NPAs for banks, which will begin to show up after the moratorium period ends on August 31. In its July Financial Stability Report, the RBI noted that the gross NPA ratio of all scheduled commercial banks may increase from 8.5% in March 2020 to 12.5% by March 2021 under the baseline scenario. If the macroeconomic environment worsens, the ratio may increase to 14.7% in the very severely stressed scenario, it added.

Experts feel that a lag in economic revival, demand in the economy, and reinstatement of income levels may lead to stress in all segments — corporates, MSME and retail – in the December 2020 quarter. If a sell-off were to start in the US, many stock markets, including in India, could be pushed into the doldrums.

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