A bubble burst is no figment of the imagination

A bubble burst is no figment of the imagination

Economic parameters appear confused and investors should not be tempted to ignore macroeconomic factors.

‘Your investment would have doubled by now, had you invested in the stock market in March 2020.’ An assertion like this triggers an urgent rush to invest in the market and is akin to being under the influence of a “feel-good” hormone. This makes the expectation of ‘winning big’ feel better than ‘just winning’ leading to impulsive, even detrimental decisions, attributable to behaviour biases, to use the terminology of behavioural economists.

Perception versus reality

Investors may not necessarily be always sensible or even capable of perceiving the larger picture. Nobel laureate Daniel Kahneman argues that humans usually use the ‘first system’ of ‘fast thinking’ to hurriedly act and perceive their environment. Consequently, they are susceptible to the ‘priming effect’, ‘framing bias’, ‘anchoring effect’, ‘overconfidence bias’ and ‘availability heuristic’.

These phenomena, thus, play their part in pervading optimistic market conditions. As a result, investors often end up ignoring or overlooking uncertainties and risks involved in their decision. They get so enamoured with the idea of making a killing that they forget that in the month of March last year itself, the market had tanked a fourth of its capitalisation causing mayhem.

At the same time, investors’ decision choices could be significantly influenced by ‘nudging’, a deliberate tactics and method of behaviour modification by which it is the ‘choice architect’ that decides who does what and who does so, as argued by the Nobel laureate, Richard H. Thaler. The present surge in the Indian stock market is indeed nudging individual investors to trade more. But who is playing the role of the choice architect and what their intentions are, remain the moot questions.

Focus on individual investor

National Stock Exchange data indicate that the share of the non-institutional individual investors in equity trading volume has risen to one half of the total turnover in 2021 as compared to around a third in 2016. In contrast, the share of Foreign Institutional Investors (FIIs) in the total trading volume has shrunk to just about a tenth making it half of what it used to be in 2016. Trading in the stock market, the sudden rise, the intraday moves, etc., are, thus, attributable largely to individual traders now.

Their large trading volumes notwithstanding, individual investors have actually contracted their holding of the market capitalisation. Going by the floating stocks of the market collectively, the FIIs currently own around half of the free float of all Indian companies. Apparently, the retail investors have constantly sold their stake to end up holding less than 20% shares now. Trading, thus, seems to be the mainstay of retail investors and this is what makes them more vulnerable to the vagaries of the market.

The market today

During the period under discussion, the fundamental, economic and environmental parameters look confused. GDP has shrunk by at least 7.5%, unemployment rate has been on the rise, and an overwhelming number of people are said to be sliding back into poverty or becoming poorer than a year before. At the same time, Centre for Monitoring Indian Economy Pvt. Ltd. data of the listed companies reveal a rise in their profit, due to rationalisation and cost-cutting.

Investors might be tempted to ignore macroeconomic factors and invest in such stock believing that it is the profit that impels the stock prices. In reality, however, share price is expected to ascend if a company declares to cut its wage bill. This probably explains why stock markets around the world have been on the rise amidst the novel coronavirus pandemic; demand may have declined but profits have been least impacted. At the larger economic level, however, real wages have plunged. Clearly, the market has not entirely decoupled itself from the economic indicators.

Stimulus or profit or euphoria caused by happy hormones, whatever the reason apart, the stock market has been drawing available excess liquidity. Simultaneously, frequent trading has been propelling the stock market further up. But how long can this last? Established wisdom suggests that corporates cannot sustain contraction in the economy for long. Sustained decline in demand caused by waning disposable household income would catch them soon.

A grey cloud

Consequently, corporates would be saddled with unsold goods or services, leading to a drop in their prices, with a consequential effect on their revenue which would exert downward pressure on their stock prices. This is, however, not to deny that stock markets are always futuristic and stock prices imitate investors expectations. But how long can expectation drive the market if the economy does not revive soon?

Robert J. Shiller, another Nobel laureate, attributes this phenomenon of creating a possible bubble to irrational exuberance. And bubbles are seldom long lasting and burst sooner rather than later. When bubbles burst, they cause a kind of financial earthquake, in turn destabilising public trust in the integrity of the financial system. Critically, as the past portrays, individual investors, with all their vulnerabilities, suffer the most devastating consequences.

Retail investors are as well susceptible to overreaction when negative news hits the market. For example, a week of turbulence eroded market capitalisation of over ₹1-lakh crore in the case of just six listed companies of the Adani group (https://bit.ly/2UW0JbM). For an individual investor, who had purchased these shares during the last month, this means that he lost his entire investment. These companies are closely held, with promoters holding around 75% stake, but imagine the mayhem if this happens to a widely held company. A bubble burst is in the realm of recurrent reality and cannot be ignored as a figment of the imagination.