Is the RBI's 'Bubble Talk' Signalling a Market Crash?

May 31, 2021

Rahul Shah, Editor, Profit Hunter

The Reserve Bank of India (RBI) has found the divergence between Main Street and Dalal Street baffling.

It has argued that the sharp rally in stocks despite an economic contraction in FY21 is posing the risk of a bubble.

The numbers do support the central bank.

India's GDP is estimated to contract by a full 8% in FY21. This is arguably its worst showing in decades.

Despite this, the stock market has galloped, closing the previous financial year with 68% gains.

Little wonder, RBI is finding it difficult to reconcile the two events.

I believe the RBI is fully justified in raising the bubble red flag.

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But to those who've been in the markets for a few decades and who understand the true nature of the beast, this may not come as a surprise.

Stock markets have a tendency of looking 12-18 months out.

They are always trying to predict what's going to happen in the near future. They are therefore a leading and not a lagging indicator of the overall health of the economy.

For those having doubts, you don't have to go too far back to clear it.

The markets crashed in February-March last year. This was because they anticipated a big blow to the economy from the Coronavirus pandemic.

And then when the smoke started clearing and the government wasting no time in rolling out support, markets began to go up again.

Thus, on both the actions, their predictions turned out to be correct and they are right on the money.

However, as if often the case, markets may have overreacted to both these events.

Perhaps there was no need for the market to be so pessimistic to crash 40% in of months.

And perhaps there was no need for the market to be so optimistic that it doubled from the lows.

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Therefore, to this limited extent, I do agree with the RBI that the risk of a bubble is certainly greater now than say a few months back.

But does this mean that the markets could crash anytime soon and you should sell everything and get into cash?

Absolutely not.

We can only say with a high degree of confidence whether the risk of a bubble is higher or lower than before.

There is no way of knowing when this risk will turn into a full blown crash.

For all you know, the markets can continue to go higher and remain at elevated levels for long.

This is why I am a firm believer of having at least 25% of your portfolio allocated to stocks at all times.

So, if the risk of a bubble being formed is high like it is right now, you can be 25% or perhaps 50% in stocks.

And if the risk is low like it was right after the 40% crash, you can take the stock exposure to as high as 75%.

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Will this approach lead to market beating returns over the long term? It can or may be it cannot.

But what it does really well is that it allows you to 'Buy low and Sell high'.

It allows you to put more money into stocks when markets crash and book profits and take money off the table when markets touch record highs.

This action alone will ensure that you will stay ahead of the majority of investors, most of whom will give in to their emotions and buy high and sell low.

It also allows you to ignore RBI's warnings and pay attention to what you need do and not worry too much about what the market is going to do.

What do you think dear reader?

Write to me and let me know your opinion.

Warm regards,

Rahul Shah
Rahul Shah
Editor and Research Analyst, Profit Hunter

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