Stock market valuations and Sebi
Small capitalisation (cap) and mid-cap stocks have appreciated by more than 60 per cent over the last year in India. Is this a bubble? If yes, what can the Securities and Exchange Board of India (Sebi) do, given its mandate? Relatedly, what should be its mandate?
While a stock price index is quite unpredictable, the same is, by and large, not quite true as far as the aggregate valuations are concerned. Valuation indicators such as priceto-earnings ratio (P/E), price-tobook ratio, dividend yield, ratio of market cap of small caps to the total market cap, market cap-to-gross domestic product (GDP) ratio, and corporate profits-to-gdp ratio tend to be somewhat mean-reverting over time, though it can take quite a while. Bubbles can arise, and while it is hard to say when a bubble will come to an end, identifying a bubble per se is not as difficult.
The Nifty Small-cap 250 index is trading at P/E of over 28. Other indicators too suggest caution. At some stage, the real returns are very likely to be low, possibly negative. Investing through index funds is no safeguard here. And, even investing through systematic investment plans (SIPS) has its difficulties in practice. So should public authorities intervene?
It is true that Sebi and the Association of Mutual Funds in India (AMFI) did recently make a public statement related to small-cap and mid-cap stocks, but it was effectively in the form of a whisper, as the emphasis was on liquidity. So why did Sebi not make a loud and clear speech on valuations? Well, it is not in the present mandate of Sebi to intervene if the valuations are very high! We have a similar story in other countries. This needs to change, but it is important to first understand the rationale for the present mandate.
Conventional wisdom holds that trades in the stock market are a zero-sum game, with little effect on the real economy, and that the pure market mechanism is reliable even in the context of the stock market. There is also a view that the caveat emptor applies, and that stock prices are naturally very volatile because they need to incorporate the changing news. Of course, some do accept that valuations can get very high at times but then they feel that this is good for real investment. All these views contribute to the final conclusion that any intervention related to the stock market valuations is undesirable. While these arguments may look reasonable, a closer examination reveals serious weaknesses. In that case, Sebi does need to intervene.
It will help to consider a different but related angle as well. The stock market can be unambiguously efficient, and Sebi does not need to intervene if ordinary investors are rational and well-informed. It can also help if a weaker condition is met, which is that there is a market for sound, credible, easily accessible, and independent financial advice at a reasonable fee. But these conditions are not met in practice. So, the regulator does need to step in. This can require a major change in mindset and in legislation. But even after the change, how can Sebi intervene in practice without violating respect for private property and people’s right to choose their asset portfolio? This column considers two actions.
First, Sebi can make regular and “loud” announcements on valuations, and require intermediaries like mutual funds and brokers to prominently display the same. Second, at present, the labelling on riskiness of products like pure equity schemes by intermediaries like mutual funds is on the basis of the general nature of the schemes; it is not based on valuations at any given time. This needs to change. This can help nudge investors towards products like (countercyclical) balanced advantage funds at a time when equity valuations are very high.
It is true that some sellers do convey concerns on valuations to their clients, but not all do. So it helps to change the mandate of Sebi. It is also true that Sebi may not be able to make perfect assessments but that is fine. And, despite the warnings, many investors may be led by the FOMO (fear of missing out) factor. But the point is not that this can be completely avoided; it helps if it can be reduced.
The public authorities often intervene in many different ways in the economy where they should not, and sometimes they do not intervene where they actually should, as in the case of stock market valuations. It is time to correct.