Mean reversal is a popular theory in investment science which states that asset prices and returns eventually return back to the long-run mean or average.Accordingly, the Indian stock market could probably undergoing a reversal to mean.
Investors are witnessing a volatile stock market, wiping out the past gains even as the rupee is heading in a downward direction. Let us discuss what went wrong and what is the course of action for investors.
Both current account deficit (CAD) and fiscal deficit (FD) are going up. In simple language, it is nothing but India imports more than it exports which lead to higher CAD, and spends more than what it earns which lead to higher FD. But, this is nothing new, this issue has been there for quite some time. But, the new dimension added is the increase in crude oil price and deprecation in Indian currency.
Role of US interest rate
The US bond yield is currently around 3.2% which is the highest it has been for years. What does this mean for investors? It means the safest investment in the world will get you 3.2% return and it also opens up the window for a windfall gain in case the yield contracts.
So, all the smart money in the world is selling their current investments across the markets and moving the same to US bond markets. Let us see how this change in the interest rate has an impact on Indian currency. Indian currency was one of the strongest currencies in the last few years and now with yields being high, funds are selling Indian currency portfolio and moving the proceeds to US dollars and the pressure is being built on Indian currency. The point to be observed is that the pressure on Indian currency is predominantly against the US dollar and not against other prominent currencies such as Singapore dollar or Pound Sterling or Euro.
Crude oil price is pinching every one. When oil price was low the government levied high taxes on petrol and diesel as it needed money when things were going good during 2015-18 and thus managed the fiscal deficit. If the crude oil price is not contained, probably it could lead to higher inflation which is a much bigger challenge.
Status of NBFCs
As of September 2017, there were 11,469 non-banking financial companies (NBFCs) registered with the Reserve Bank of India. More than 82% of them have been categorised as high-risk financial institutions by the finance ministry. NBFCs are facing liquidity pressure after infrastructure financier IL&FS defaulted on multiple payments since late August. Defaults by a systemically important NBFC have made investors worry about the sector, raising their cost of funds and making access to liquidity difficult. Several non-bank lenders including housing finance companies have slowed down loan disbursement and are deferring high-value loans.
Mean reversal is a popular theory in investment science which states that asset prices and returns eventually return back to the long-run mean or average. Accordingly, the Indian stock market could probably undergoing a reversal to mean. Indian currency is falling and erasing all the gains of last four years and going back to the same rate ratio with other currencies and the stock market is adjusting its price earnings ratio to go back to the mean.
What is the course of action? Stock market indices and the home currency have fallen sharply in the past too and there is no reason why the prices cannot go up if business models are sustainable and macro-economic factors are good. As long as you are a long-term investor, there is nothing to panic. Do not exit the market by winding up your portfolio and thus booking losses.
The writer is professor of finance & accounting, IIM Tiruchirappalli