REASONS, EFFECTS AND CAUTION.
Amidst a plummeting GDP and tyrannical first and second wave of covid-19 the Nifty and Sensex index managed to hit an all time high.
As seen above during the 2008 crisis there was a deep plunge and recovery happening.
A similar plunge took place in March 2020 followed by a sharp recovery in November the same year.
What does this sharp shooting stock mean for us? FPI? Domestic investors?
Sensex refers to top 30 out of the listed companies on Bombay stock exchange and Nifty refers to top 50 out of total listed companies on national stock exchange.
On 23rd March 2020, two days before nation wide lockdown, ratings fell as low as 25981 points and crossed 43,882.25 mark on November 2020!
The rise of equity markets have surprised investors creating a surrounding of uncertainty.
A major reason behind this surge is the rampant inflow of Foreign Portfolio investment into the economy, reaching Rs138,107 crore in FY2021.
FPI refers to short term capital investment in financial assets to increase capital availability and does not interfere with employment of labour and wages.
FDI ( foreign direct investment ) refers to long term investment in physical assets to boost productivity and enterprise capacity causing a direct impact on labour and wages.
On the other hand domestic investors including mutual funds are busy booking profits out of the sharp rise in markets and indicates a huge pullout of around Rs 30,000 crores.
Mutual fund spreads investment across sectors and industries with a professional fund manager managing your investment resulting in less volatility and a bonus of tax benefit if investing in tax saving mutual fund called equity linked saving schemes.
An equity investment is money that is invested in a company by purchasing shares of that company in the stock market.
Mutual fund investors invests when market is down and make the best out of the opportunity to exit making money after market goes high. They liquidate their holdings to obtain maximum cash out of their investment.
Now what does all this money in the market mean?
We need to first understand the basic monetary tools used by RBI.
Repo rate- Rate at which RBI lends money or securities to bank. Presently it is 4%.
Reverse repo rate- Rate at which RBI repurchases these securities from banks. Presently it is 3.35%.
Cash reserve ratio (crr) - Percentage of bank’s total deposit that needs to be kept as cash with RBI. A high crr means banks have less to lend, thereby curbing liquidity to prevent inflation.
Liquidity is a measure of cash and other assets that can quickly be turned into cash(like central bank reserves and government debt) to settle immediate or short term bills. A financial institution must always maintain enough liquid assets higher than its liabilities to protect against losses like withdrawal by investors.
The RBI can increase the lending rate to adjust the inflation rate but currently it is in no hurry to do so and there is a flush of liquidity in the system. All this cash flows into equity markets.
Hence there is a prevailing caution amidst investors to invest in quality stocks other than penny stocks.( low valued stocks say less than 10Rs with low trading frequency).
The US election outcome and successive announcements of vaccine trials by leading vaccine makers have fueled more FPI inflows. But market participants must remain wary of this surge and maintain due diligence while investing in large caps to mid and small caps, pharma , IT, banking and infrastructure sectors.
What is the difference between bonds and stocks?
Bonds are like loans that an entity sells to raise money. For example if I want to open a new clothing store but I don’t have enough money at present then I can pitch this idea to investors who would lend me money. In exchange I promise them to return the same with interest after a specific period of time.
But stocks are equity instruments that’s considered as taking ownership of the company. For example to raise money immediately I can sell 10 shares out of total 50 shares of my company’s stock. Hence those buyers are entitled to proportionate share of earnings.
But if I were to collapse and go bankrupt, I will first have to repay bond holders before I receive any amount. Hence shares are subjectable to higher risks despite better returns.
What happens during inflation?
Naturally investors seek higher returns to beat inflation .But as yield rises bond price drops and vice versa. Why so?
Bond yield is the amount paid as interest as a percentage of current price.
Par value of a bond is amount of money bond issuers promise to pay at maturity date of the bond. It does not include interest.
Zero coupon bonds are those that do not pay interest at return but derives value from the discount that is the difference between value at which it was sold and the final par value.
Say I purchased a bond with x% yield. But later due to inflation interest rates rise and newly issued bonds are having y% yield where y>x. Definitely I would want to purchase the newer bond because a higher yield is profitable for me.
So to attract demand of investors like me, the price of the previous bond with x% yield will have to decrease enough to match the final yield return of the y% bond. This leads to price drop of a bond.
If instead new bonds had z% rates and z<x then the first issued x% bond would have been the best option to purchase. In that case the person selling x% return bond will push its price up further until total value during time of return matches that of the z% yielding bond.
Therefore market value of these investments always fluctuates and is subject to inflation. But a little bit of inflation is necessary for GDP growth because it ensures circulation of currency in the system. When inflation rate increases out of control things get risky.
RBI’s dovish policy has kept fueling the rise in stock market. It means RBI has no intention of increasing the lending rate to curb inflation because the governor believes price gains are transitory.
Overseas investors keep notice of this trend leading to net inflow of $7 billion this year, the highest in Asia.
These factors have facilitated a bull run in the market. ( A bull run means market that is on the rise and conditions are favorable. A bear run indicates receding economy with stock value declining.)
SEBI has cautioned investors from pulling out fully from traditional sources of investment like banks because stocks always have juicier rates of interest returns. Though low interest rates facilitates liquidity, any change in easy lending policy will impact the market itself. (Equities have retreated in Russia, Brazil, South Korea after banks raised their rates.)
Any sort of investment must be made only after background check and ensuring stable business.
The total foreign currency owned by the government.
The RBI keeps dollars in reserve for necessities like oil purchase. In 1991 fiscal deficits and poor economic policies piled up, leading to a huge economic crisis and drying up of foreign reserves. The then central govt pledged gold holdings with bank of England to raise its forex reserves.
Currently due to Federal Reserve Bank of USA releasing dollars into the market coupled with huge foreign investments in Indian companies like that of Facebook in Jio, our forex reserves have hit an all time high of 4% of GDP and is the 5th largest pool of forex reserves. They amount to 1.1 times that of India’s external debt of $563.5 billion. This has boosted confidence of financial markets.
RBI purchases large quantity of surplus dollars arriving in the market which adds to forex reserve and in exchange supplies rupees into the economy.
These reserves are kept for transactions, speculative and precautionary motives.
The liberalized remittance scheme of RBI allows individuals to remit certain amount of money during a financial year to another country for investment and expenditure. This money can be used for medical treatment, donations , education , share investment and so on. They offer legal channels to invest on foreign assets.
In addition the IMF has allocated 12.57 billion special drawing rights (SDR’s) to India. They are units of account for the IMF and represent a claim to currency for which they may be exchanged.
These factors coupled with slashing of corporate taxes has surged investments in the country. An investor or trader must always be on the lookout for right time to invest but must proceed with caution.
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