Markets touch record highs on back of greater confidence over economy. Optimism needs to be tempered with caution

On Thursday, the BSE Sensex breached the historic 50,000 mark for the first time. While the markets have since then been pulled down by profit booking, the near 90 per cent rise in the Sensex from the depths observed in March last year has been nothing short of spectacular. Moreover, this surge has not been concentrated in a few select stocks, but is more broad-based with the BSE mid and small cap indices also witnessing a similar surge. Foreign investors have also flocked in droves — between April 1 and January 21, foreign portfolio investors invested a net of Rs 2.41 lakh crore in Indian equities, the highest ever in a single year. Retail participation too has seen a spectacular pick up — around 10 million new demat accounts were opened in 2020. All this suggests that despite the economy going through arguably the severest recession in decades, market participants are optimistic about future prospects.

There are several possible explanations for the surge in the markets. First, there is far greater optimism over the state of the economy than before with leading economic indicators suggesting that a strong recovery is underway. Add to that expectations of a smooth rollout of the Covid vaccine and as a consequence, demand firming up, especially for high-contact services, there is reason to be optimistic. This view was echoed by economists at the RBI in their latest monthly outlook on the state of the economy, who noted that “the recovery is getting stronger in its traction and soon the winter of our discontent will be made glorious summer,” adding that “barring the visitation of another wave, the worst is behind us”. Second, there are heightened expectations from the upcoming Union Budget. Considering that the government has been rather conservative in its approach this year, there are expectations that the finance minister, in addition to announcing steps to aid the economic recovery, will loosen the fiscal taps, providing the much-needed fillip to the economy. And third, favourable liquidity conditions, both domestically and globally, are playing a significant role in pushing up stock prices.

However, there is reason to be cautious. Even though markets are forward-looking, valuations appear to be stretched. The market is currently trading at a price to earnings ratio of 34 that is far in excess of its long term average. While earnings will get upgraded, this expansion in the earnings multiple will at some point adjust to the reality that the economy still has a considerable distance to travel to recover to pre-COVID levels. Even accounting for the faster recovery, the economy is likely to recover to 2019-20 levels, only by around the end of 2021-22.

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