Do the stock markets reflect economic reality?

The stock markets have been on a wild ride. After 1-2 month of severe volatility, they have been rallying for the past few weeks.

But everyone is questioning the recent recovery. They believe it will not sustain. And why should it? The numbers don't add up. Other than the Unlocking 1.0 announced by the Government there has been no significant change in the current downtrodden economic situation:

• Covid-19 cases haven’t slowed down in India

• April industrial production numbers (under lockdown) were dismal

• Rating agencies have downgraded the expected GDP numbers

• Corporate Earnings were not good

But the stock markets are relentless. Begging the question, do the stock markets reflect the economy? Or is this a one-off situation?

No, stock markets do not reflect the economy. At least not the current economic reality. So if you tell me, ‘the stock markets are rising, the economy must be doing well’, chances are you are wrong. As stock markets rise or fall in anticipation of where the economy will be. They don't dwell on the current affairs but move in anticipation. Think of them as a preview of things to come, a 'leading indicator'.

The price of the stocks (companies) that make up the stock markets tends to be forward-looking. Every investor understands that the value of a company today is a function of its future earnings. And a large part of the earnings is defined by the prospective economic growth of a country. So if investors expect higher economic growth they’ll invest now expecting the companies to perform well.

Unfortunately, strong economic growth does not always transform into increased profitability for a company

As several other factors can spoil the party.

• Governments can raise taxes, eating away a chunk of profits

• Inflation can increase costs hampering profitability, Eg: raw material costs or wage inflation

• Excited managements can make wrongful capital employment decisions. (Several good companies went belly up after acquiring unprofitable businesses at high valuations before the 2008 debacle.)

Successful investors understand all this, using it to generate strong returns. They make informed decisions, betting against everyone based on research and experience.

The fact that the stock market is a 'leading indicators' of its respective economies applies to all countries.

But the Indian stock market is a relatively weak indicator

Mainly as the influence of foreign investors affects our markets, making them sensitive to global developments. This dilutes our stock market's ability to reflect economic reality.

Take the recent rally for example. Whereas the unlocking did contribute to the rally, the primary reason was the stimulus packages announced by Governments world over. As a part of the global liquidity infusion flowed into the Indian stock markets resulting in the upswing.

But foreign inflows are not unusual

They have been investing in the country ever since 1992. Often referred to as Foreign Institutional Investors (FIIs, foreign money) they account for a large percentage of investments in the Indian Stock market even today. Hence their decision to invest or divest also has an overbearing effect on the index.

In 2008, owing to the Lehman crisis, the Indian stock markets crashed as foreign money (largely U.S.) flew out of the market. The more recent 2015 market crash was also due to a global sell-off as a result of the Fed's tightening along with commodity prices crashing.

Over the years, domestic investors have gone up but not significantly enough to shield the Indian Equity market from the effect of foreign money. Unfortunately, their overbearing effect on the Indian equity markets is likely to continue over the next few years.

But just because our stock markets are affected by global factors doesn't mean the economic growth is irrelevant

The Indian stock market, over the last 2 decades, has clocked an annualised average return of around ~14-15%. But only on the back of strong economic growth. So to gauge the pace of stock market returns, understanding economic growth is essential. As it eventually drives stock market returns over the long-term.

But assuming the stock market reflects the economy would be wrong.