The first quarter of 2021 saw a number of record highs. Nifty and Sensex hit record highs. The value of Bitcoin hit an all-new record high. Real estate was no different with record high valuations coming in from various major cities around the country. These record highs are not just limited to traditional stock market investments. Fixed commodities like the Rolls-Royce Phantom on auction in February were sold at a staggering Rs 4.8 Crores. While a Rolex Daytona watch was sold for a record-breaking price. All these record-breaking valuations are causing many people to wonder, how much higher can this possibly go? And most importantly are we looking for an eventual bubble in the near future?

In this blog, we are going to look at the trends over the last few months from a stock market perspective. We will also note that if the inevitable were to happen, what would be the best ways to navigate these difficult market conditions.

How Did We Get Here?

When the lockdown was at its peak in 2020, Sensex tanked almost 40% (from 42,000 to 26,000), while Nifty took almost 50% (from 12,000 to 7,500). This drastic drop created major panic among investors. Lo and behold, In the course of a few months some magic happened. Both Nifty and Sensex saw the rally of their lifetime: Sensex rose from 26,000 to the current level of 52,000, which is a 100% jump. At the same time, Nifty rose from 7,500 to 15,300, which is also a 100% jump. All this happened within a span of 1 year.

How Are These Changes Perceived?

In order to understand the impact of this sudden rise in the Sensex and Nifty, it’s first important to first understand “The Investor”. Investors can be classified into two major categories: new investors and veterans. New Investors have little or no experience in the stock markets and have entered the platform after the recent rally. It is quite possible that these investors have not witnessed a bear market. Veterans on the other hand are individuals who have been trading for a considerable amount of time. These individuals understand the game of valuation. They know that the markets are overvalued and hence have not heavily invested at this time.

So, who is right from a valuation perspective? And is the stock market overvalued and most importantly, what will happen if the valuation will burst in the future?

Is the Stock Market Overvalued?

This is quite literally the million-dollar question that most people want answers to. On one side, the entire country is trying to recover from the Covid19 pandemic, and the GDP has seen a drastic shrinkage in the last year or so. But on the other hand, the stock market has almost doubled since the lows in march 2020. So why did the stock market move in the opposite direction? Ideally, when the economy does not do well, the stock markets news should also follow a similar trend. This is primarily because the stock markets are dependent on the company’s performance which is dependent on the economy.

PE Ratio

To understand whether the stock markets or company is overvalued, a good indicator is the PE ratio. The PE ratio can be defined as the:

PE ratio = price per share / earnings per share

Historically the Nifty PE ratio ranges between 15-25. In the event that the PE ratio falls below 20, you can say that the market is undervalued. PE ratio between 20-25 indicates that the market is fairly valued. If the PE ratio crosses 25, then the conclusion is that the stocks are overvalued. To understand this a bit better, let’s look at an example.

During the 2008 financial recession, the Nifty PE reached a peak PE of 28.4 just before the US housing bubble. Once the stock markets crashed, the Nifty PE saw a drastic fall to 10.8. This is a good indication that the market was overvalued before the crash when it was at 28.4.

On average, the Nifty PE value remains between 20-25, where it is defined as being fairly valued. At present the Nifty 50 PE is 42, which as you can imagine is insanely high.

Market CAP to GDP Ratio

Another good indicator of overvaluation is Market CAP to GDP ratio. This indicator suggests the valuation of the stock market compared to the GDP of a country. In India the market cap to GDP ratio is around 75%. This means that the Indian stock market valuation is 75% of the GDP. However, in recent months the market cap to GDP ratio has touched 100%.

In conclusion, both the PE ratio and market cap to GDP indicate that the stock market is overvalued and a market bubble is imminent.

What Has Caused the Bubble?

There are primarily two reasons that have led to the market bubble.

Impact of Covid and Subsequent Lockdowns

During the post lockdown period, there was a sharp fall in earnings (denominator of PE ratio). If the denominator falls, it’s inevitable that the PE ratio would go up. As the economy gradually recovers, the earnings would increase and that would see a lowering on the PE ratio.

Exorbitant Rise in Share Prices

The second reason for the over valuation is the exorbitant rise in share prices. But the question is, why did the share prices rise when the economy tanked? To understand this, it’s first important to understand the dynamics of the US stock markets. India being a huge market for US investors through FII (Foreign Institutional Investors). The Indian stock market over the months saw a greater dependency on FII. This influx of foreign money in the stock market saw a drastic jump in valuations in the share market.

These two reasons why the Indian stock market is seeing greater-highs even though the GDP and overall economy is not doing so well.

Final Thoughts

It’s only a matter of time before the US investors will start pulling back money from the Indian markets, at which point this bubble is bound to burst. This will result in a correction in the stock market where it will gradually return to fair value ratios. For investors looking to ride out this challenging time its best to take a conservative approach to the overvaluation of markets. In short, it’s prudent to not put all your eggs in one basket. Diversifying investments and spreading out your financial risks will ensure you get the most out of the current market situation while not falling prey to the eventual bubble.