There is a possibility that with a rise in the market, retail investors will return to market only to bite the bullet when irrational exuberance gets replaced with realism

The upward movement in the stock market in the past three days has taken many by surprise, including those who have claimed themselves to be conventional bulls. Around 800 points rise in the Sensex without any substantial changes in the ground reality, raises questions which are difficult to answer. It is pertinent to note that just two weeks back markets across world were worried about the US “fiscal cliff”. Without any solution of the fiscal cliff issue, the sense of déjà vu is back in leading markets across world including the Indian market. Some experts are attributing this rise in the market to improvement in sentiments while some others are pointing out that FIIs (foreign institutional investors) have once again started showing keen interest in the Indian stock market. 

Whatever be the logic of those who argue in favour of the upside movement in the market, there are good enough indicators pointing out the beginning of a new phase of “Irrational Exuberance”.  Irrational exuberance, here, does not essentially reflect what Alan Greenspan stated in 1996 but what it definitely reflects is that investors have once started overlooking intrinsic value of stocks and chasing stocks believing that all is well and the markets will continue to rise.

Here are three factors which reflect why it may be return of irrational exuberance in the market:

Economic fundamentals continue to remain weak: There have been no substantial changes in the broad economic fundamentals either at the global or the local level. In fact, the broad fundamentals have weakened. The GDP (gross domestic product) data released on 30^th November shows that economic growth continues to remain sluggish with Q2, 2012 GDP growth rate at 5.3%. There is no sign of GDP growth picking up but there is only hope. Are there any obvious reasons for growth to pick up even next year? Hopes and expectations don’t contribute to growth but investments do. Where will the investments come from? FDI, insurance and aviation reforms are not good enough for this. Domestic investment environment need to improve. The problem does not end here. The picture on the fiscal deficit front continues to remain grim, as well. As per the latest report, the fiscal deficit in the first seven months of current financial year has already reached 72% of target for the full year,  indicating the fact that there is going to be slippage on fiscal deficit front. Higher fiscal deficit would mean rise in inflation and lesser probability of drop in interest rates.

Rupee depreciation and external front of the economy:  The rupee continues to play the game of hide and seek. The volatility in the currency with predominant downward bias is not good for the economy. If the rupee continues to fall, attracting investments in the stock market will be challenging. It is obvious that a depreciating rupee means lesser return for foreign investors. It is true that FIIs have brought some money into stock market in the month of November but this looks like hot money waiting to return in the second half of December 2012. Another worry for currency is the burgeoning trade deficit. The trade deficit for April-October 2012-13 was estimated at $110,212.91 million which was higher than the deficit of $106,805.58 million during April -October 2011-12. The rising trade deficit will put pressure on the currency further.

Inflation continues to high and interest rates are unlikely to come down soon:  There is very little respite on the inflation front and this could result in the RBI (Reserve Bank of India) continuing with the tight money policy in the days to come. If the interest rate remains high, growth will continue to remain retarded. In spite of RBI mentioning that the cost of capital is not a deterrent for economic growth, many small businesses continue to suffer because of the rising rate of interest and investment demand in general is not picking up.
 

Some people would argue that stock markets are not always driven by fundamentals alone and hence equating movements in the market to ground realities is not a fair assessment of things to come. However, we cannot ignore the fact sooner or later the stock market will start reconciling itself with the ground reality. There is a possibility that with a rise in the market, retail investors will return to market only to bite the bullet when irrational exuberance gets replaced with realism.

Read other articles by Vivek Sharma, here.

(Vivek Sharma has worked for 17 years in the stock market, debt market and banking. He is a post graduate in Economics and MBA in Finance. He writes on personal finance and economics and is invited as an expert on personal finance shows.)