Lead Story

Delirium in the Markets

Market regulator SEBI says there is “froth” in the mid-and small-cap stocks; banker Uday Kotak says there is no bubble. Caught in this cross-current are traders in small towns who are betting heavily in risky derivatives. What is next for the turbocharged Indian markets and what of the retail investors rallying behind it?

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Published 2 months ago on Mar 27, 2024 17 minutes Read
Illustration: Saahil Bhatia

Mahesh Kumar, a 32-year-old resident of Gaya, Bihar, earns Rs 25,000 a month as a salesman at a mobile phone showroom in Delhi. Inspired by YouTube videos by financial influencers, he invested all his savings in the stock market without any insights of his own. He recently bought a bike for over Rs 1 lakh with his earnings from the market.

  • Twenty-year-old Krishn Vohra from Yamunanagar in Haryana decided to drop out of college and get into full-time stock trading instead of a formal job. According to him, it is better-paying. 
  • Mohammad Afzal from Lohardaga in Jharkhand earns Rs 15,000 as a cab driver in Delhi. Having seen YouTube videos on trading, he is convinced he can make more money from the stock market. He is further encouraged by the profit he had earned once.

For Kumar, Vohra and Afzal, who hail from smaller towns where people are perceived to be frugal and cautious with their money, the plunge into an unchartered territory like the stock market, with little or no understanding of its workings, defies logic.

Jobs are scarce, retail inflation, especially food, is high, opportunities for growth are minimal and skill sets limited. In such a reality, the only way Kumar & Co. can jump on the Viksit Bharat bandwagon is to take risky bets with their money.

Anil K. Sood, professor and co-founder at the Institute for Advanced Studies in Complex Choices, Hyderabad, says that in an environment where income growth is low, the pressure to build wealth through riskier investment leads a lot of people, especially youngsters, to venture into stock markets. “When there is so much positive narrative about the economy and the current growth rate is high, the propensity of people to believe in the invincibility of stock markets is high. They feel that the best way to supplement their income, which has seen sluggish growth, is not through their jobs but trading in the stock markets,” he says.

This mad rush to get rich quickly has baffled many. It led to Securities and Exchange Board of India (SEBI) chairperson Madhabi Puri Buch to issue a warning. Last month she said there is “froth” in the mid- and small-cap space and the bull run was “not supported by fundamentals at all”. She went on to call the run an “irrational rally”. The bull run in the mid- and small-cap stocks has been fuelled by the burgeoning numbers of retail investors.

The Rise of Smaller Players

Retail investors emerged as a strong buying force after the pandemic when all segments of the markets posted good returns. But this story is not concentrated in a few urban centres of the country. Brokerage firms report that a large part of new investor addition is happening from Tier II and III cities.

Brokerage firm Angel One reported that 60% of gross client additions happened from Tier III towns in 2022–23. Its data for the period between the first quarters of 2021–22 and 2023–24 shows that most new client additions were recorded from these towns in all the quarters. In its earnings call for the October–December 2023 quarter, the company informed shareholders that 80–85% of customer acquisitions were happening from Tier III and beyond.

At an industry event in 2022, trading app Upstox’s co-founder Shrini Viswanath said that contrary to the 2010–11 phase where 90% of the customers came from the top seven cities of the country, over 80% of new customers on the app came from Tier II and III cities in 2022.

BSE’s registered investors database also shows that poorer states like Bihar, Chhattisgarh, Uttar Pradesh and Jharkhand are recording higher year-on-year growth in investors joining the market than Delhi, Maharashtra and Gujarat.

“The V-shaped recovery of the market after the fall during the Covid-19 pandemic indicated to investors that good money can be made,” says Aditya Kondawar, partner and vice president at wealth management firm Complete Circle.

However, the euphoria of retail investors has sprung up worrying signs across the country’s capital markets. Kumar is lucky that he has not suffered any losses yet, but his lack of any knowledge of the markets leaves him at the mercy of those who advise him.

Afzal’s only trading wisdom is that one must buy shares when they are cheap—a guiding principle that even made him consider buying shares of the beleaguered Paytm when its price fell after the Reserve Bank of India’s action against it. His 19-year-old brother quit his job at a small shop in Daryaganj in Delhi to do full-time trading in the stock market.

A major factor that lures many of these investors to trading is the easily available advice from finfluencers—financial influencers—who make stock-trading seem like child’s play.

Kondawar says that a lot of suggestions floating on the internet may have contributed to the behaviour of investors. “The internet is filled with content on the stock market where someone is promising exceptionally high returns in a short period of time. How can one ask an investor to bet their savings on a stock in a 30-second reel,” he asks.

The Finfluencer Phenomenon

While new age finfluencers are thriving, trusted legacy players like Motilal Oswal Financial Services, Edelweiss Mutual Fund and SBI Securities lag far behind with followers in the range of 13,000–2.5 lakh. To put this in perspective, the Instagram page of one of the most followed finfluencers has 24 lakh followers, while another has 17 lakh.

A large share of investors thronged to online platforms like YouTube, Instagram, WhatsApp, X and Telegram. A survey report of National Centre for Financial Education showed that only 27% of the respondents in India were financially literate in 2019.

While the number of unregistered finfluencers swelled, that of registered investment advisers has barely changed. SEBI data shows that India has 1,300 registered intermediaries acting as investment advisers. This number stood at around 1,299 in March 2023, according to some reports, showing that not many have been added to the regulatory ambit. In October last year, SEBI said that 35% of investment advisers were still not registered with the regulator.

The Advertising Standards Council of India (ASCI) had said in 2023 that online content creators could only offer investment advice after being registered with SEBI. But that does not seem to have deterred the so-called experts.

Taking cognisance of the impact of finfluencers on the stock market, in August 2023, SEBI released a consultation paper, proposing to ban partnerships between SEBI-registered entities and unregistered finfluencers, among other measures. It also banned several finfluencers.

The Market Mirage

The benchmark Sensex fell to 27,590 in April 2020 from 41,170 in February. However, in November that year, it was able to cross the pre-pandemic level. During the post-Covid surge, while Sensex delivered returns of over 163%, Nifty provided investors with returns of more than 171%. On March 6 this year, Sensex achieved a historic milestone, reaching 74,000 for the first time. Simultaneously, Nifty 50 kicked off 2024 with the third-fastest 1,000-point surge in its history, crossing 22,000 in January.

When the markets revived after the 2020 crash, the number of retail investors entering the stock market saw a steep rise. According to Goldman Sachs data, between 2012–13 and 2019–20, the number of demat accounts in the country grew from two crore to 4.1 crore at a compound annual growth rate (CAGR) of 10%. This rate jumped to nearly 41% between 2019–20 and 2022–23 when the number of accounts increased from 4.1 crore to 11.4 crore.

An analysis of market segments also reveals a pattern of heightened enthusiasm among retail investors. In the initial public offering (IPO) market, between 2018 and 2020, only six out of 274 IPOs saw retail subscriptions exceed 50 times. However, between 2021 and 2023, out of 510 IPOs, 131 recorded oversubscriptions by more than 50 times. According to Neeraj Chadawar, Head of Fundamental and Quantitative Research at Axis Securities, this increase is because of buoyancy in secondary markets. He says, “The rally in the secondary market has led to increased liquidity among investors, which is then redirected towards IPOs.”

Concerns over company valuations extend beyond the IPO market. The influx of liquidity into small-cap stocks by retail investors has driven up company valuations significantly, posing concerns for seasoned investors. The small-cap segment saw strong returns, thanks to their considerable interest. While Sensex gained 18%, the small-cap index surged by nearly 48% in just one year, reflecting retail investors’ increased allocation to this segment.

According to data from the Association of Mutual Funds in India (AMFI), as of December 2019, large-cap fund portfolios totalled 95 lakh, while small-cap funds accounted for 50 lakh folios. However, the latest release for December 2023 reveals a notable shift: small-cap fund folios surged to 1.69 crore, surpassing large-cap funds, now at 1.32 crore.

An analysis by Outlook Business of 512 small-cap companies shows that the average price-to-earnings (P/E) ratio surged from 28.8x to 48.7x between December 2019 and 2023. Industry experts view trading above the 40x ratio as a red flag. To contextualise, benchmark Sensex trades at a P/E ratio of 25x. A similar trend is observed in mid-cap stocks, as per an analysis by Kotak Institutional Equities. The average P/E ratio in their consumption universe soared from 36.7x to 47x between the financial years 2019 and 2024 (estimated).

The Risk Factor

Data compiled by Marcellus Investment Managers shows that retail ownership of free-floating stocks—shares available to the public for trading—posted good gains compared to domestic mutual funds and foreign institutional investors (FIIs). Between the December 2020 and 2021 quarters, the retail investors’ ownership of free-floating stocks jumped from 17.9% to 19.6%. In the same period, the share in ownership of such stocks by FIIs reduced from 43.3% to 39.9% while mutual funds’ share went up marginally from 14.7% to 15%.

The momentum in the markets is a fairytale for many retail investors. The pace in additions of new investors suggests that just like Kumar, millions across the country want to make the most of this euphoria at the bourses. But seasoned investors fear that many new investors joining the markets are not considering that markets follow cycles, and the current bull run will not last forever.

The pursuit of high returns has not only led investors to chase stocks without fundamental explanation but also engage in speculative trading through futures and options (F&O). There are two forms of derivatives trading which traders use to speculate on the prices of a stock. Generally, they are used by experienced traders to hedge risk on the stocks they own. However, it is now being used by lakhs of retail investors as a mode of speculative trading despite not having adequate knowledge or experience. SEBI’s analysis of a sample consisting of the top 10 brokerage firms’ data revealed a worrying trend in retail investors’ participation. Between 2018–19 and 2021–22, the number of retail investors in equity F&O increased by over 536% to 45.2 lakh in 2022 from 7.1 lakh in 2019.

Due to this, the country’s derivatives market volume has reached a dangerously high level compared to its cash market, where the actual purchase and sale of stocks or bonds happens.

An Axis Mutual Fund report showed that as of July 31, 2023, the derivatives-to-cash volume ratio stood at 422x in India. Globally, this ratio stood at 36x for Germany, 12x for South Korea and 9x for the US. A high ratio can lead to higher volatility and affect overall market stability.

Siddhartha Bhaiya, managing director and chief investment officer at Aequitas Investment Consultancy, a SEBI-registered portfolio manager, says it is a horror story of how delirious and inexperienced traders are engaging in risky derivative trading. “With weekly expiries, F&O have become like gambling for many traders. What was supposed to be a hedging instrument has now become a purely speculative tool for many new investors, which is dangerous,” he says.

SEBI showed in its analysis that 89% of individual traders in the equity segment made losses in the equity F&O market in 2021–22. This gambling-like problem for retail investors in pursuit of high returns through any investment instruments necessary has not only become a headache for the market regulator but also sprung up a problem for law enforcement agencies of the country.

Field Day for Fraudsters

The National Crime Records Bureau’s 2022 report hints at a rising propensity of people to fall for fake promises of fraudsters. Economic offences in the country rose by 11% in 2022 over the previous year, with forgery, cheating and fraud accounting for a maximum number of such cases. Across the country, cases of stock market-related fraud are being reported where individual investors are targeted through online messaging platforms like Telegram and WhatsApp. In February 2024, Mumbai Police arrested two people in connection with a pan-India fraud where investors were made to download a fake trading app and then duped of Rs 28 crore in total. Individual traders from Delhi, Maharashtra, Odisha and Gujarat were defrauded in the case. As per the details of the case, the arrested persons were part of a gang which had duped over 100 investors from across the country.

According to Anoj Menon, senior partner at Desai and Diwanji, a law firm, many retail investors fall for fraudulent investment advertisements as they chase high returns in a highly inflationary environment. “The fraudsters take the money from investors and show them high profits through screenshots or a fake app. However, the problem occurs when these investors try to redeem the fund and realise that they have been defrauded,” he says.

Stock market-related frauds have been reported in Delhi, Mumbai, Hyderabad, Kolkata and Pune among other cities in the past few months. This has prompted law enforcement agencies to issue advisories about online trading scams.

“While financial crimes were prevalent earlier as well, the increase in participation from retail investors has widened the base these fraudsters can target. In such a scenario, the regulator must work harder to protect the interests of investors,” says Tomu Francis, partner at Khaitan and Co., a corporate law firm. Francis feels that the problem of risky investment behaviour is compounded by the fact that financial advice is available easily to gullible retail investors over the internet and other means from unregistered investment advisers and bad actors. “Moreover, the sophistication of products and frauds have increased in the past few years due to the rapid rise of retail investors,” he adds.

The dangerous rise of speculative trading, the increase in fraudsters taking advantage of retail investors and the formation of valuation bubbles have put the spotlight on SEBI.

SEBI’s Red Flag

The response to Puri’s warning became visible immediately. Sensex pulled back from its March 6 high to the 72,000 range in the following week. Nifty too fell below 22,000 by March 19.

While the markets have seen several such falls in the past few years, the recent developments are an indication that retail exuberance may have gone too far, which the regulator is now trying to correct.

Aequitas’ Bhaiya agrees that the valuation situation in the Indian markets is worrying. “What started as a healthy trend of retail investors pumping in money in beaten-down segments during the Covid-19 pandemic has now become a big valuation problem. Markets immediately need a moderation to control this,” he says.

Kotak Mutual Fund imposed restrictions on inflows into small-cap funds. It was probably the first institutional investor in September 2023 to raise an alarm about the behaviour of retail investors. It said in a note, “We see the limited point in trying to find fundamental reasons behind the steep increase in stock prices of several mid-cap and small-cap stocks. There is no meaningful change in the fundamentals of most companies; in fact, they have worsened in many cases. The primary driver of the rally appears to be irrational exuberance among investors.”

On the other hand, Uday Kotak, founder and non-executive director of Kotak Mahindra Bank, part of the same group as Kotak Institutional Equities, disagreed that the markets were in a serious bubble phase. At a SEBI conference on March 13, shortly after Buch’s observation, he said, “I believe at this stage, we are nowhere near that risk and there are enough checks and balances in our system today to compare ourselves in serious bubble territory.”

In May 2023, SEBI directed trading platforms to display investment risks, especially in the F&O segment. The Reserve Bank of India also voiced concerns over excessive liquidity in cash and derivatives markets, potentially influenced by speculative trading. Regulators are worried that borrowed funds may be driving speculative investments, blurring the line between investing and gambling.

Realising that previous measures were not sufficient to curb risky investor behaviour, SEBI urged AMFI in February 2024 to manage inflows into small- and mid-cap schemes to protect investor interests. This move sparked market instability, with the Sensex falling over 800 points on February 28. Following SEBI’s directive, Kotak Mutual Fund and ICICI Prudential Mutual Fund placed restrictions on lumpsum investments in small- and mid-cap schemes. Some other fund houses followed suit.

When the Music Stops

Vijay Kedia, a veteran stock market investor with a portfolio worth over Rs 1,500 crore, raises caution that most new investors are putting their money into the market based on speculation. “A small proportion of investors are investing after proper research and analysis while the remaining are just shooting arrows in the dark, treating investing in markets as gambling and a way to make quick money.”

According to Kedia, many of the new investors lack proper knowledge of the market fundamentals. “As most of them have entered the market during a bull run, they feel that nothing can go wrong. They do not take into account the possibility of a bear market. Many such investors will suffer severe losses whenever the market cycle shifts in future,” he warns.

The concerns over valuations are rising at a rapid pace. Global investment firm Bernstein reportedly told its clients in a note in the first week of March that it is struggling to offer new investment ideas. As per the firm, the small- and mid-cap space is in a bubble, and it will enjoy the returns till the music stops.

Realising that valuations are at elevated levels, promoters of companies are offloading their stake to make the most of the situation. An analysis by ICICI Securities of the top 1,000 stocks over the calendar year 2023 showed that promoters of these companies constituted 40% of overall selling flows.

US-based promoters of Whirlpool were in the news recently when they decided to sell a 24% stake in its Indian subsidiary. In an interview with CNBC, Whirlpool Corporation chief executive officer Marc Bitzer said that the company was positive on India, but it wanted to make the most of the high valuations. At the time of the stake sale, Whirlpool was trading at a P/E of over 50 at the bourses.

The bubble in the small- and mid-cap segment is a problem from the broader market perspective as well because the trading volume of Nifty 100 as percentage of Nifty 500 has reduced significantly, an analysis by investment platform FundsIndia showed. This suggests that the stability of broader markets depends on the performance of lower-value stocks. From close to 70% in January 2019, the trading volume of Nifty 100 as percentage of Nifty 500 fell to 47% at the end of February 2024. Talking about valuations, the FundsIndia analysis noted that the valuations in the small-cap space are so high that even after a 25% correction, small cap would remain expensive.

The numbers suggest that a correction in the space is inevitable. SEBI has moved in to protect the broader markets, but analysts say that many retail investors are set to learn their lessons the hard way.

Bhaiya says that the consequences of a fall this time around could be severe for many across the country as the retail investors’ base has never been so high and geographically diverse. “I do not know whether the new investors who have joined the markets understand the risks that are associated with trading. But the shifting of the cycle to bearish is inevitable,” he says.

SEBI’s data reveals a significant increase in young investors in the age group of 20–30 participating in the speculative derivatives market. In 2018–19, this age group accounted for only 11% of the total base, but by 2021–22, it surged to 36%. Axis MF analysis further highlights that the average age of investors trading through discount brokers is 29 years, similar to the average age of 31 for fantasy sports participants.

SEBI’s recent concerns focus on market safety, with potential soft measures such as advising caution among market participants. Unfortunately, actions against finfluencers and risk advisories have not curtailed the momentum of retail investors. Despite SEBI highlighting that most of the individual traders made losses in the derivatives segment, markets are set to close the current year with a record volume of contracts in the F&O market. National Stock Exchange data shows that the number of F&O contracts traded in the current financial year till March 8 stood at 8,889 crore, a 112% rise from the volume recorded in 2022–23.

The inflows through mutual funds continue to hit record highs and so do the benchmark indices. It appears there is a feeling of invincibility among the retail investors. Seasoned investors are convinced this will not end well for many.

Gaurav Manihar, business head of franchisee–broking and distribution at Motilal Oswal Financial Services, notes that many young investors from smaller cities are driven by the desire for rapid wealth accumulation, often making uninformed decisions. “As people become more financially literate, they will begin to tread cautiously, taking calculated risks wherever they venture. But for now, the risks they are embracing are far from calculated,” he adds.

This explains Kumar’s blind faith in the market’s ability to toil while he slumbers, unaware of the potential losses. As regulators tiptoe delicately between regulation and the euphoric bull run on the Indian stock market, the looming consequences of market frenzy may soon weigh heavily upon ordinary Indians.