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Confidence/Exuberance: The Wedge between Asset Prices and Real Economy

Real and financial economy

The part of the economy that is concerned with actually producing goods and services, as opposed to the part of the economy that is concerned with buying and selling on the financial markets. It is believed that there should be a rational relationship between the real and financial market. Real market is reflected by the gross value added at the basic market price (GDP at basic market price). The financial market’s movements, upward or down ward are indicated by share market indices (in India’s case it is Sensex or Nifty). The movement in asset prices is also observed in prices of real estate (especially housing sector) and precious metals (gold and silver). If there is a divergence between the real and financial economy, economists suggest that there is some problem, sometimes very serious mismatch which may cost a lot to the economy and people.

Effects of mismatch in real and financial sectors

If the financial economy is growing too much faster as compared to real economy, it indicates that speculative activities are growing faster than real economic activities, i.e, increase in production and value added in various sectors of the economy such as agriculture, manufacturing and services. This is an indication that a “financial bubble” is in the making, which would burst sooner or later. Such bubbles are first observed in the stock markets, real estate and other asset prices. On the other hand if the real sector is growing faster than financial sector, this means that there are problems and in the banking sector, lack of trust in the capital market and something amiss in saving and investment habits of people. All these problems lead to slowing down of deposits and credits and investment in precious metals rather than capital market.

In recent past we have seen how bubbles were created in the cpital market and housing sector in the United States that led to sub-prime crisis (2007-08) and financial crisis turning finally into global recession. This also led to sinking of banks and financial institutions and loss to small investors as the bubble burst. Such occasions have been seen in the past in India when small investors lost their capital after stock markets fell from height. It was a Terrible Tuesday (January 28, 2008) for the bourses. The Sensex saw its biggest intra-day fall when it hit a low of 15,332, down 2,273 points. However, it recovered losses to some extent and closed at a loss of 875 points at 16,730. Trading was suspended for one hour at the Bombay Stock Exchange after the benchmark Sensex crashed to a low of 15,576.30 within minutes of opening, crossing the circuit limit of 10 per cent. At the time of suspension, the Sensex was quoted at 15,576.30 points, plunging 2029 points (11.53 per cent) from Monday’s close.  Investors on Tuesday lost over Rs 6 lakh crore (Rs 6 trillion) within minutes of opening of the Bombay Stock Exchange, which was immediately suspended for an hour after the 30-share barometer index, Sensex, hit the circuit limit of 10 per cent. This loss of Rs 6,54,887.85 crore (Rs 6.548 trillion) comes on top of over Rs 11 trillion loss suffered by investors on the Dalal Street in the last six days. The Sensex and Nifty saw its second biggest intra-day loss on Monday. Relentless selling saw the index crash to a low of 16,951 – down 2,063 points (10.8%) from the previous close.

The Indian Stock markets in 2016

By December 2016 the Sensex had fallen by over 3,000 points, largely due to weak quarterly earnings and falling crude oil prices. Other domestic factors such as mounting non-performing assets (NPAs) also weighed on the minds of the investors. The second week of the month saw the Sensex taking its biggest hit — a fall of over 6 per cent. Post February, the indices managed to keep the investors on the edge but a correction ensued. The first shocker of the year — the Brexit vote results — sent the market into a frenzy. The United Kingdom had voiced its opinion to ‘leave’ the European Union. On June 24, the Sensex shed over 600 points and the Nifty bled 180 points. The fall was not just restricted to companies having exposure to the U.K. market, such as Tata Motors, Tata Steel, Infosys, Bharat Forge and Tech Mahindra. The panic selling seen across sectors was one of the biggest overreactions this year, so much so that Finance Minister Arun Jaitley and the then RBI Governor Raghuram Rajan had to intervene to soothe the nerves of retail investors. Even cautious retail investors ran for cover as FIIs sat on the sidelines and the domestic institutional investors (DIIs) continued to sell.

Subsequently after passing of the GST, in the following month, the Sensex inched towards the 30,000 mark, a level that it had first hit in March 2015. The Nifty was making steady gains to cross 8,700 levels. But, the eighteen month-high levels were short lived. In the last days of the month, an announcement of surgical strikes on terror launch pads across the border sent an already weak market into a tailspin. On September 29, the Sensex recorded a fall of over 400 points and the Nifty ended 1.76 per cent lower, at 8.591.25.  FIIs and DIIs, however, lapped up the opportunity, investing Rs. 3,413 crore and Rs. 1,630 crore, respectively.

An analysis of stock market movements in 2017

In 2017, the Indian stock market appeared  more robust. The Indian stock market seems unstoppable. Its major indices have risen over 20% this year, making it one of Asia’s best performers. Indian investors have piled into more than $7.2 billion worth of stock in 2017 and foreigners have bought almost $7 billion. Some foreign investors have decided that Indian stock prices have run far ahead of fundamentals; they’ve begun to shed some of their India holdings in the last couple of months. But Indian investors have happily taken up the slack—even though it’s hard to find anyone reasonable in Delhi or Mumbai who claims that earnings will recover anytime soon. And this domestic interest in stocks appears broad-based. A few years ago, Indian mutual funds were declared near death. Now they are having a great year—with much of the impetus coming not from larger cities but from India’s smaller towns, many of which are largely virgin territory for actively managed mutual funds. Mihir Sharma wrote in Livemint on September 24, 2017 that it is not all good and rosy. While this seems like good news—Indian policymakers have long wondered how to get Indians to trust their savings to financial markets—there’s a worrying corollary. If ordinary Indian households that have never thought about stocks before are so starved for access to financial instruments that they’re forced to buy into an overvalued market, the country is setting itself up for a sharp correction that may have much wider repercussions than anything it’s had to deal with so far. This is something that leaders should be thinking about carefully. The Indian government is, like most governments, always willing to advertise its successes, and it has billed the stock market’s performance as one of them. In fact, it’s a sign of failure: The government simply hasn’t been able to broaden access to other more preferable forms of finance—forms that are either safer or more accessible. Microfinance institutions were decimated by “demonetisation”, as the cash ban was called. India’s state-owned bank sector has notably failed to provide remunerative rates for savers, its attention fixed on dealing with a slow-moving bad loans crisis. The government’s social security schemes are poorly designed and their tax treatment makes them unattractive. Meanwhile, the government itself is running out of money. It’s already blown through over 90% of its fiscal deficit for the year. Uncertain about the fiscal implications of its big new indirect tax regime, it has no clear idea where its money in the next quarters will come from—and that means that its ambitious infrastructure plans are less likely to come to fruition.  Isn’t there something deeply wrong with this big picture? India is awash with savings and its households desperately want somewhere safe and lucrative to put that money. Its government wants to invest in infrastructure, but doesn’t have the tax receipts to pay for it. What India needs is a pipeline from its household savings to the infrastructure that it needs to build. In the past, tax-exempt highway bonds have been attractive to Indian savers. The government needs to push for more such instruments—and bend some of its considerable persuasive power to getting people to invest in them. That would be good news all round—except, perhaps, to those betting on the Indian stock market to keep powering ahead for the foreseeable future.

Ten biggest falls in Indian Stock Markets in past

Jan 21, 2008: The Sensex saw its highest ever loss of 1,408 points at the end of the session on Monday.  The Sensex recovered to close at 17,605.40 after it tumbled to the day’s low of 16,963.96, on high volatility as investors panicked following weak global cues amid fears of the US recession.

Jan 22, 2008: The Sensex saw its biggest intra-day fall on Tuesday when it hit a low of 15,332, down 2,273 points. However, it recovered losses and closed at a loss of 875 points at 16,730. The Nifty closed at 4,899 at a loss of 310 points. Trading was suspended for one hour at the Bombay Stock Exchange after the benchmark Sensex crashed to a low of 15,576.30 within minutes of opening, crossing the circuit limit of 10 per cent.

May 18, 2006: The Sensex registered a fall of 826 points (6.76 per cent) to close at 11,391, following heavy selling by FIIs, retail investors and a weakness in global markets. The Nifty crashed by 496.50 points (8.70%) points to close at 5,208.80 points.

December 17, 2007:  A heavy bout of selling in the late noon deals saw the index plunge to a low of 19,177 – down 856 points from the day’s open. The Sensex finally ended with a huge loss of 769 points (3.8%) at 19,261. The NSE Nifty ended at 5,777, down 271 points.

October 18, 2007: Profit-taking in noon trades saw the index pare gains and slip into negative zone. The intensity of selling increased towards the closing bell, and the index tumbled all the way to a low of 17,771 – down 1,428 points from the day’s high. The Sensex finally ended with a hefty loss of 717 points (3.8%) at 17,998.  The Nifty lost 208 points to close at 5,351.

January 18, 2008: Unabated selling in the last one hour of trade saw the index tumble to a low of 18,930 – down 786 points from the day’s high. The Sensex finally ended with a hefty loss of 687 points (3.5%)  at 19,014. The index thus shed 8.7% (1,813 points) during the week. The NSE Nifty plunged 3.5% (208 points) to 5,705.

November 21, 2007:  Mirroring weakness in other Asian markets, the Sensex saw relentless selling. The index tumbled to a low of 18,515 – down 766 points from the previous close. The Sensex finally ended with a loss of 678 points at 18,603.  The Nifty lost 220 points to close at 5,561.

August 16, 2007: The Sensex, after languishing over 500 points lower for most of the trading sesion, slipped again towards the close to a low of 14,345. The index finally ended with a hefty loss of 643 points at 14,358.

April 02, 2007: The Sensex opened with a huge negative gap of 260 points at 12,812 following the Reserve Bank of India decision to hike the cash reserve ratio and repo rate.  Unabated selling, mainly in auto and banking stocks, saw the index drift to lower levels as the day progressed. The index tumbled to a low of 12,426 before finally settling with a hefty loss of 617 points (4.7%) at 12,455.

August 01, 2007: The Sensex opened with a negative gap of 207 points at 15,344 amid weak trends in the global market and slipped deeper into the red. Unabated selling across-the-board saw the index tumble to a low of 14,911. The Sensex finally ended with a hefty loss of 615 points at 14,936. The NSE Nifty ended at 4,346, down 183 points. This is the third biggest loss in absolute terms for the index.

Economic Survey on mismatch between asset prices and growth fundamentals

 A variety of indicators in India point to a possibly short-run deceleration of economic activity, over the course of 2016-17. A number of indicators—GDP, core GVA (GVA excluding agriculture and Government), IIP, credit, investment and capacity utilization— point to a deceleration in real activity since the first quarter of 2016-17, and a further deceleration since the third quarter. Real GVA growth for Q4 2016-17 was 5.6 per cent. Unless potential output growth is much lower than is commonly assumed (around 7 percent or more), output gaps are expected to widen. Economic Survey 2015-16 Volume I had predicted a range for GDP growth of between 6.75 and 7.5 percent, factoring in more buoyant exports as global recovery gathered steam, a post demonetization catch-up in consumption, and a relaxation of monetary conditions consequent upon demonetization.

Yet, during this period, especially since February 2017, asset prices have risen. For example, the decline in G-sec yields from a high of 7.12 percent to 6.5 percent implies higher bond valuations. 1.45 More strikingly, over the same period, stock prices have risen to record levels, with the Sensex climbing from 28,743 to 32,020, a gain of 11 percent, equivalent to 15 percent in US dollar terms. Moreover, the price-earnings (P/E) ratio of the Indian stock market reached a level of 23 in May 2017, and is estimated to have reached about 25 by mid-July. This is substantially greater than the long-run average of 18, and not far from the frothy levels reached in 2007. Whether profits and growth surge— because the recent deceleration proves transitory, or asset valuations adjust—in other words, rational confidence or overexuberance— remains to be seen. Historical evidence suggests that there is mean reversion towards more realistic valuations, especially when global excess liquidity is driving high valuation in the first place.

Gold Prices Movement in India in recent times

We Indians are the largest consumers of gold in the world, there is no other population in any other country that has a demand for gold as strong as ours. In fact, gold constitutes 12.50% of our total imports (in FY 2012-2013), which is a whopping $61,409 million. Fluctuations in prices affect the purchasing behavior as a lot of Indians buy gold as a “safe” investment. Gold is viewed as a commodity by those who invest in it, and these investors constantly watch the market for fluctuations that could mean a potential profit, or the possibility of acquiring the asset at a lower price. Gold has over the years been a perfect hedge against inflation. Investors are increasingly looking at gold as an important investment.

In 2016, the lowest price recorded was Rs.24,910 per 10 grams on January 1st 2016. Gold prices soared to Rs.32,336 per 10 grams on 6th July 2016, the highest price recorded for this year. In the first half of the year, gold performance was low but showed an upward trend in the second half. The main events that affected gold rates this year included the jewellers strike against strike PAN card regulations, the Brexit vote, the expectations of an interest rate hike by the U.S. Federal Reserve, the festive and wedding seasons, Trump’s win in the U.S presidential elections and PM Modi’s demonetisation scheme.

By September 23, 2017, Gold was  weighed down by slackening demand as prices dropped Rs 50 to Rs 30,800 per 10 grams even as the metal strengthened overseas. Demand softness also led to silver tumbling by Rs 200 to Rs 40,500 per kg as industrial units and coin makers kept to the sidelines. Globally, gold rose 0.50 per cent to USD 1,297.10 an ounce and silver 0.27 per cent to USD 16.98 an ounce in New York. In the national capital, gold of 99.9 per cent and 99.5 per cent purity shed Rs 50 each to Rs 30,800 and Rs 30,650 per 10 grams, respectively. It had climbed Rs 350 in yesterday’s trade.  Sovereign, however, remained unchanged at Rs 24,700 per piece of eight grams in limited deals.

Real estate prices

After passing of benami property acts and steps against black money and demionitisation, there is slackness in housing purchases and prices have decreased in the range of 10-20 percent according to various estimates. Trends in real estate price in India show that global capital inflow into Indian real estate will increase further, developers would revamp their business models, private and public partnership may grow further and in the next round of development there would be more thrust on affordable houses. Passing of RERA would also instill confidence.

Theoretical explanation of bubble in asset prices

An economic bubble or asset bubble (sometimes also referred to as a speculative bubble, a market bubble, a price bubble, a financial bubble, a speculative mania, or a balloon) is trade in an asset at a price or price range that strongly exceeds the asset’s intrinsic value. It could also be described as a situation in which asset prices appear to be based on implausible or inconsistent views about the future. Asset bubbles date back as far as the 1600s and are now widely regarded as a recurrent feature of modern economic history. Historically, the Dutch Golden Age’s Tulip mania (in the mid-1630s) is often considered the first recorded economic bubble.

Because it is often difficult to observe intrinsic values in real-life markets, bubbles are often conclusively identified only in retrospect, once a sudden drop in prices has occurred. Such a drop is known as a crash or a bubble burst. Both the boom and the burst phases of the bubble are examples of a positive feedback mechanism, in contrast to the negative feedback mechanism that determines the equilibrium price under normal market circumstances. Prices in an economic bubble can fluctuate erratically, and become impossible to predict from supply and demand alone.

While some economists deny that bubbles occur, the cause(s) of bubbles remains disputed by those who are convinced that asset prices often deviate strongly from intrinsic values. Many explanations have been suggested, and research has recently shown that bubbles may appear even without uncertainty, speculation, or bounded rationality, in which case they can be called non-speculative bubbles or sunspot equilibria. In such cases, the bubbles may be argued to be rational, where investors at every point are fully compensated for the possibility that the bubble might collapse by higher returns. These approaches require that the timing of the bubble collapse can only be forecast probabilistically and the bubble process is often modelled using a Markov switching model. Similar explanations suggest that bubbles might ultimately be caused by processes of price coordination.

More recent theories of asset bubble formation suggest that these events are sociologically driven. For instance, explanations have focused on emerging social norms and the role that culturally-situated stories or narratives play in these events.

India has not seen any big enough bust

Monetary and fiscal policies in India have been major safeguards against any major bust in the past. Normal corrections take place due to the operation of market forces. But in the past government and the central bank in India have moved generally in sync to promote growth and maintain price stability. Also SEBI has been strengthened to maintain stability in the stock market and ensure fair play and safety of the small investors. Recently, government has made stringent laws and government departments are maintaining strong vigil on real estate prices and gold prices.  In the past the Indian capital market has moved according to global trends. Today there is some concern why the India stock market is moving upward without not having so strong macroeconomic fundamentals. But market would lead itself to corrective movements. Meanwhile government needs to be cautious and vigilant.

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