Mutual Funds Clearly Point to a Stock Market Bubble


One sign of the stock market being overheated is when retail investors start entering it, dime a dozen. One way of checking this phenomenon out is looking at the kind of money coming into equity mutual funds, month on month.

So, let’s look at the total amount of money coming into mutual funds every month since January 2013 (I am not using an arbitrary cut off point here. The database that I use has monthly data from January 2013 onwards). The total amount of money coming into equity mutual funds is basically referred to as net investment, which is the total sales of equity mutual funds minus the total redemptions from these funds.

Take a look at Figure 1. Figure 1 basically plots the net investment into equity mutual funds month on month, over the last five years.

Figure 1: 

What does Figure 1 tell us? It tells us that a lot of money has been invested into equity mutual funds in the current financial year (i.e. between April 2017 and December 2017). In fact, 40 per cent of the money that has been invested in the equity mutual funds from January 2013, has been invested in the current year.

This, when the price to earnings ratios of stocks have been considerably high. At the beginning of April 2017, the price to earnings ratio of the Nifty 50 stocks was at 23.4. By end December 2017, it was close to 27. This means that at the beginning of the financial year, an investor was ready to pay Rs 23.4 for every rupee of profit that the Nifty 50 companies made. By the end of the year, this had jumped to Rs 27.

The average price to earnings ratio of the Nifty 50 stocks since January 1999 is 19.1 (again this is the data that is available in the database that I have access to).

This basically means that while stock prices kept rising, the earnings of companies, of which stock prices are ultimately a reflection of, did not rise at the same speed. The same logic stands for indices other than the Nifty 50 as well.

Let’s take the case of Nifty 500. The price to earnings ratio of Nifty 500 which was at around 26.8 at the beginning of the financial year, rose to 32.6 by the end. This basically means that as the stock market has become more expensive, it has attracted more and more retail investors, who have invested their hard-earned money, through the equity mutual fund route.

The law of demand basically states that there is more demand for something when prices are low and vice versa. This clearly does not work in case of the stock market. A bulk of retail investors get attracted to it, only after the market has become fairly expensive, which has clearly been the case since April 2017.

Let’s look at a little more mutual fund data. Figure 2 basically plots the yearly net investment in equity mutual funds since financial year 2003-2004 (again this might seem like an arbitrary cut off, but the database I have access to, has yearly data from 2003-2004).

Figure 2: 

As per Figure 2, the maximum amount of money that ever come into equity mutual funds has been in 2017-2018, and we aren’t done with the year as yet.

In fact, what is also clear from the table is that, as the stock market goes higher, more money comes into equity mutual funds. This trend is clearly visible between the years 2005 and 2008, also. Close to Rs 40,800 crore came into the stock market in 2007-2008, when the stock market was fairly expensive for most of the year. On January 8, 2008, the price to earnings ratio of the Nifty 50 touched a high of 28.3. The next couple of years, when price to earnings ratio of the Nifty stocks was in fairly inexpensive territory, barely any money came into equity mutual funds.

This tells us very clearly that retail investors buy when the markets are fairly expensive, instead of doing the other way around. The same story that played out between 2005 and 2008, is playing out all over again. Hopefully, a new set of investors will learn the same set of lessons, all over again. Meanwhile, the fund managers of mutual funds continue to remain bullish on the stock market. But they more or less always are. It’s worth remembering here that a mutual fund makes money as a proportion of the total amount of money it manages. And a bull market remains the best time to raise money.

Of course, all this comes as always comes with the caveat of John Maynard Keynes, “the market can remain irrational, longer than you can remain solvent”.

Postscript: I am happy to share with the readers of the Diary that the Business Standard newspaper has carried a review of my book India’s Big Government-The Intrusive State and How It is Hurting Us.

“India’s Big Government: The Intrusive State & How It’s Hurting Us is an unconventional, interdisciplinary book that cuts across sectors of banking, infrastructure, education, manufacturing and industry, land, taxation, and employment in post-Independence India, underscoring the necessity for the state to more effectively address critical matters, rather than attempting to do “too much,”” the review points out.

You can read the full review here. (To read the review open it in the internet explorer browser).

You can buy the book here.

The column originally appeared on Equitymaster on January 12, 2018.