Stock market indices say little about economic growth

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Stock markets are an enigma from which there is little escape. At times, it seems as if the S&P BSE Sensex and NSE Nifty have become synonymous with everything that is happening in the country, including events that transcend the economy. High readings of the purchasing managers’ index (PMI) are routinely interpreted as a sign that the economy is buoyant, and this leads to stock-index gains. 

Surprise news on election outcomes or of tighter capital norms for lending applied by the bank regulator can create an upheaval as share prices respond. These are micro responses that are discussed endlessly in the media on a daily basis. But the bigger picture often painted relates to the state of the economy. It is often assumed that a rising stock index is indicative of broad confidence in the economy and acts as a foreteller of its performance. How far is this true?

A stock index represents the shares of a specific set of companies. The Nifty’s formula includes 50 such firms. Therefore, when the Nifty moves up by 5%, say, it is akin to saying that the cumulative market value of the shares of these 50 businesses has risen by 5%. This being so, using this metric to represent the entire economy is an overstretch of the logic of representation. 

The economy is much bigger than these 50 firms (30 in case of the Sensex). Even indices that include the country’s top 100 or 500 companies cannot represent all commerce across the economy. While the market value of these businesses is very large and all big news developments that impact the economy also tend to affect these indices, at least for a few trading sessions, they do not form any kind of representative sample.

Those who swear by markets are usually driven by Adam Smith’s version of them. Many cite the ‘efficient markets hypothesis’ which argues that publicly traded equity prices take into account all possible information on economic conditions and prospects in real-time and so stock-price trends can tell us how the economy is faring in the medium term. There can be short term variations due to announcement or news effects, but, at the end of the day, an equilibrium will reflect the state of an economy. Or so goes the argument.

Let’s map India’s GDP growth rate against important business numbers. For a practical comparison, apart from the Nifty, let’s also look at growth in the net profits of Nifty companies. Stock prices, after all, are supposed to reflect the financial position of these companies as measured by their profits.

If we map out changes on three major variables—GDP growth, the Nifty and net profits of this index’s constituent companies—the picture that emerges is mixed. Take the first two. In 2015-16, when the economy did very well, the Nifty declined by nearly 9%. In 2020-21, the pandemic caused a GDP contraction, but the Nifty registered its highest increase in a decade. 

In 2022-23, a GDP growth rate of 7% was accompanied by a marginal decline in the Nifty. The coefficient of correlation between these two variables was -0.56. This makes it hard to convincingly argue that stock market movements reflect the overall growth of our economy. In fact, a negative correlation means that high growth in one variable tends to go along with low growth in the other.

However, a strong link is seen between the latter two variables; that is, when Nifty movements are compared with growth in the earnings of its component companies (as represented by net profits). This is only to be expected, as there is a direct connection between the market valuation of a company and its performance in terms of earnings. Here, the coefficient of correlation is a high 0.79.

Another indicator we can use is the elasticity of Nifty changes to profit changes. This shows responsiveness. Excluding 2016-17, which was an outlier in terms of company profits, affected as it was by a demonetization slowdown, this elasticity has been as high as 2.31. This means that the stock index tends to increase by more than a commensurate increase in net profits.

This analysis argues for moderation in how we interpret stock index movements. They certainly reflect the health of listed companies, especially constituents, which is logical. The profit orientation of stock markets is not in doubt. But extending the explanatory power of index movements to cover the growth prospects of an economy is inadvisable.

In case we spot an occasional lock-step, it would be more on account of a coincidence than any causal relationship. Hence, while indices may rise in response to dribs and drabs of good news on some aspect of commercial activity in the country, we can expect them to revert to their mean levels soon. This phenomenon is visible whenever there is news on monsoon prospects, with the Nifty going one way or another and companies related to the farm sector affected more than others.

It would be tempting to conclude that analysts tend to exaggerate the role of stock-index movements when they project the course of an economy. On a lighter note, it could even be said that an excessive emphasis placed on market indices by the media does us a favour, as it forces us to place index movements in the context of the bigger picture—which is the country’s economy.

These are the author’s personal views.