Stock market indexes tell us little about economic growth

Surprise news about election results or banking regulators tightening capital requirements for lending can cause havoc as stock prices react. These are micro-reactions that are discussed endlessly in the media every day. But the bigger picture is often painted in relation to the state of the economy. Rising stock indexes indicate widespread confidence in the economy and are often considered to foretell its performance. How true is this?

A stock index represents the stock price of a particular company. The Nifty formula includes 50 such companies. So, for example, if the Nifty rises by 5%, it is equivalent to a 5% rise in the market capitalization of the stocks of these 50 companies. If so, using this indicator to represent the economy as a whole is an overreach in the logic of representation.

The size of the economy is much larger than these 50 companies (30 in the case of Sensex). An index that includes the top 100 or 500 companies in a country cannot represent all commerce in the entire economy. The market value of these companies is quite large, and all big news developments that affect the economy also tend to impact these indexes, but for at least a few trading sessions, they are not representative of any kind. No sample is formed.

Those who pledge allegiance to the market are usually driven by Adam Smith’s version of the market. The “efficient market hypothesis”, often cited by many, states that the prices of listed stocks take into account all information about economic conditions and prospects in real time, and that stock price movements therefore reflect how the economy is doing over the medium term. That’s understandable. Although it may fluctuate in the short term due to announcements and news, ultimately the equilibrium reflects the state of the economy. Or so will the argument.

Let’s compare India’s GDP growth rate with key business numbers. For a real comparison, apart from Nifty, let’s also look at the net profit growth of Nifty companies. After all, stock prices are supposed to reflect the financial health of these companies as measured by profits.

A mixed picture emerges when we plot changes in three key variables: GDP growth, Nifty, and the net profits of the index’s constituent companies. Get the first two. In 2015-16, when the economy was doing very well, the Nifty fell by nearly 9%. Although GDP contracted in 2020-21 due to the pandemic, Nifty recorded its highest growth in a decade.

The GDP growth rate in 2022-23 was 7%, but the Nifty declined slightly. The correlation coefficient between these two variables was -0.56. This makes it difficult to convincingly argue that stock market trends reflect overall economic growth. In fact, a negative correlation means that high growth in one variable tends to be accompanied by low growth in the other variable.

However, there is a strong link between the latter two variables. That is, when we compare the movement of the Nifty with the growth in revenue (expressed in net profit) of its constituent companies. This makes sense, as there is a direct relationship between a company’s market valuation and its earnings performance. The correlation coefficient here is high at 0.79.

Another metric that can be used is the elasticity of changes in the Nifty to changes in earnings. This shows responsiveness. Excluding 2016-2017, which was an outlier in terms of corporate profits due to the slowdown in demonetization, this elasticity reaches 2.31. This means that the stock index tends to rise more than commensurate with the increase in net income.

This analysis argues for moderation in how we interpret stock index movements. These certainly reflect the health of listed companies, especially their constituents, which is logical. There is no doubt that the stock market is profit-oriented. However, it is unwise to extend the explanatory power of the index’s movements to cover the economy’s growth prospects.

If you occasionally find lockstep, it’s probably due to chance rather than cause and effect. Therefore, although the index may rise as more and more good news regarding some of the domestic commercial activities comes in, we can expect it to quickly return to average levels. This phenomenon is seen every time there is news regarding the monsoon outlook, the Nifty moves in one direction or another, and companies associated with the agriculture sector are affected more than others.

It is tempting to conclude that analysts tend to exaggerate the role of stock index movements when predicting the course of the economy. On a lighter note, you might even say that the media’s overemphasis on market indexes is to our advantage, as it forces us to view index movements within the overall picture of the country’s economy. not.

These are the author’s personal views.