Why is There a Disconnect Between Stock Market and Economy? | Espresso


Feeling a disconnect between markets and the economy? Here's advice on the way forward!

June 25, 2021
Feeling a disconnect between markets and the economy? Here's advice on the way forward!

Globally, markets are witnessing an unprecedented rally, with almost all indices hitting all-time highs. This is even though economies are experiencing low or negative growth due to COVID lockdowns.

What's fuelling the rally?

The rally is widely believed to be led by the “easy money” policies of global central banks, such as near-zero interest rates and quantitative easing (QE) programs. Such policies have succeeded in putting money into the hands of the common man, increasing his spending and investing power. A surge in global money [called Foreign Institutional Investors (FIIs)] into Indian stocks has created a “risk on” sentiment towards the market.

This ongoing rally is also fuelled by the strong inflows from small/first-time retail investors. They have been gripped by FOMO (Fear of Missing Out). The fear of missing out on taking advantage of this strong bull run is attracting retail investors to the markets by the hoards. The record number of new demat accounts opened during the pandemic is proof of this.

The big question on everyone's mind is how long will this momentum last. As per the main factors that indicate how pricey the stocks are (such as price-to-earnings ratio and price-to-book value), stocks are trading at their highest levels in decades.

Worried about the “disconnect”?

If you’re new to the stock market, you might find this contrast between stock market behaviour and the nation’s economic health alarming. Here are some guidelines to help you navigate this unusual scenario and safeguard your investments. Firstly, you need to identify whether you are in the market as a trader or an investor. 

If you are a Trader

This means you are in the market to trade stocks and are looking to earn returns in the short and ultra-short terms. It is not prudent to bet against stocks just because you believe markets are overvalued. You need to understand that the current rally is driven by strong liquidity flows. Trying to swim against the current can be highly risky. There is plenty of literature that suggests that riding the momentum is one of the best ways to profit from the market. One should always trade in the direction of the trend is the biggest thumb rule of the stock market.

Always remember the two adages: The trend is your friend and Don't fight the Fed.

How to identify a trend?

You can do so with the help of many technical tools that tell you when the momentum is intact and the larger trend remains in the upward direction, and when it seems to be weakening. A good read about them will definitely help.

If you are bullish on stocks and reaping profits from it as a trader, remember to not confuse luck with skill. One should not get carried away and should always trade based on skills/strengths. The famous quote of Warren Buffet: A rising tide lifts all boats gives the message loud and clear.

It is important to avoid betting against the market at all costs unless you are a seasoned player and really believe you can identify a market top. Remember John Maynard Keynes' legendary quote: The market can remain irrational longer than you can stay solvent. Hence, it is important to maintain prudent risk management and not bet too much, especially when the market is suspected of getting into bubble territory.

If you are an Investor

Are you looking to invest in stocks and earn returns in the long term? If so, then the rules get much simpler. Your asset allocation plan, which defines what percentage of your assets should be in stocks, has an inbuilt safety mechanism. For instance, if you should be keeping only 40 percent in stocks, the rise in stock prices will automatically increase this portion. This means that all you need to do is sell off the excessive part to bring your equity investments back to 40 percent and put them into the assets that had become lower.

At the same time, if you are an active investor, for the most part, you shouldn't let the market levels bother you. This means that you should be purchasing stocks if you find them within your comfort zone, and remain patient if you think stocks are overvalued.

It is important to understand that the above approach could hurt you in the short term, and one should be prepared for some under-performance. It is always prudent to keep a small portion of your portfolio to bet on stocks that are in favour, even if they appear overvalued. This will also force you to look at the holistic picture, where you can examine why the market is rising with an open mind instead of being sceptical about the rally.

If you still remain sceptical of the market, remember the golden rule: The market is a discounting machine and looks at the future and not the present. Just because the economy is struggling now doesn't mean that it will not bounce back in the future. And markets tend to go up before the economy bounces back. Once you have truly understood this, you can maintain a healthy balance of optimism and scepticism, which will help you make an informed strategy on investing.

Happy trading and investing with Espresso!

Disclaimer: Investment in securities market are subject to market risks. Read all the related documents carefully before investing. Please refer the Risk Disclosure Document issued by SEBI and go through the Rights and Obligations and Do’s and Dont’s issued by Stock Exchanges and Depositories before trading on the Stock Exchanges. Brokerage will not exceed the Exchange prescribed limit.

R. Kalyanaraman
by R. Kalyanaraman

Chief Executive Officer

I am a sales guy at heart with utmost willingness to listen to people – customers, employees, competitors et al. Nothing gets me a bigger adrenaline rush than an interesting conversation with my customer!