Share prices today are a function of profits tomorrow. When they rally, they do so in anticipation of a sustainable growth in profits. When interest rates are low, share prices rally.This is a phenomenon witnessed in the US and other rich countries where near-zero interest rates have resulted in benchmark indices touching a new high. The stock market rally in India is different from advanced economies, says the Economic Survey. Share prices are rallying not because investors expect a strong profit growth in businesses.
Despite relatively high-interest rates in comparison to the US, share prices are touching a new high every other day. The convergence in share price gains in India and US is not a natural development, hints the Economic Survey.The Indian government is claiming that demonetisation has induced significant flows into Indian equity markets.
The logic is simple. ‘Unattractive’ other assets are pushing Indian investors to allocate more money to equities. This is reflected in a falling equity risk premium.The money thus flowing into equity markets has reduced the equity risk premium (ERP) or the extra return required on shares compared to other assets. It also indicates that investors in India are looking at equity markets favourably.
“What appears to be driving India’s valuations are a fall in the ERP reflected in a massive portfolio re-allocation by savers towards equity in the wake of policy-induced reductions in the return on other assets,” says the Survey.This really means that people are not bothered about high valuations of shares and are willing to pay a higher equity risk premium or ERP. It is due to other traditional avenues of investing cash and surplus money becoming unattractive.
The survey explains that the price of an asset is not solely determined by the expected return on that asset. It is also determined by the relative returns available on other assets.It suggests that the gov-
ernment’s campaign against illicit wealth over the past few years, exemplified by demonetisation, has in effect imposed a tax on holding of cash, property or gold.
“Cash transactions have been regulated; reporting requirements for the acquisition of gold and property have been stiffened. In addition, rupee returns to holding gold have plunged since mid-2016, turning negative since mid-2017,” the survey said.
Regulatory requirements for gold, cash and property are similar to that of owning shares. This has resulted in many investors shifting to financial assets. This is reflected in high flows in mutual funds.
However, sustaining this growth momentum will require future growth in line with expectations and people not pulling out money from equities in the near future.
(The writer is Publisher and Founder at Simplus Information Services Pvt Ltd)