Highs and Lows – How Connected Are Stock Prices and Economic Growth?
India’s benchmark equity indices are reaching new highs every day in the background of the pandemic. This is in contrast to economic indicators like the Index of Industrial Production (IIP) which have been registering a decline. Now, this may seem like a mismatch, especially since stock prices are considered as indicators of the very firms in the economy. So, why are these indicators – that are supposed to show various sides of the same picture – telling different stories?
One possible explanation is the recent increase in liquidity – the COVID-19 pandemic has led to institutions such as the Reserve Bank of India loosening their purse strings a bit. However, this can’t be the sole reason as this phenomenon isn’t unique to the pandemic period.
Extensive research has already been conducted around the topic and responses vary from both sides of the argument. There are those who believe there is a positive relation between stock prices and economic growth and others who think that the overall relationship has broken down long ago since the 1990s.
Another reasoning for the lack of correlation could be if the economy is experiencing an ‘asset bubble’. An asset bubble rises when any sector, such as housing, stocks, or commodities like gold, sees a quick and huge increase in price. The tricky part of such an inflation is that it isn’t tied to any permanent increase in value but an unexplainable investor optimism that’s hard to predict. This means that, as quickly as the prices go up, the tendency for a devastating crash is equally possible.
This brings us to our next point of order – an economy is a larger representation as compared to the stock market. Often, other factors influence the predictions of economic growth to a greater extent than the stock market, such as domestic and international political relations, private consumption trends (imported chocolate vs. Dairy Milk), etc.
One of the better explanations for the lack of correlation between both factors may be the prolonged occurrence of an asset bubble. Share prices can be driven beyond their intrinsic value when driven by non-fundamental factors, unlike economic growth. This is why really experienced and qualified portfolio managers go beyond the pricing to look at the skeleton of the company – corporate governance, fundamental valuations, and ground-level insights of employees and investors.
Why are stock market prices taken as indicators of economic growth?
We began by assuming that stock prices are fair indicators of the health of an economy. But why is this fact taken at its face value?
Okay, let’s get technical for a bit. How do we arrive at the value of share prices? We divide the present value of the sum of profits (dividend payments) we expect in the future. We all must be familiar with the process of discounting, which is what we use to arrive at the present value of expected cash.
The rate at which we calculate this is usually referred to as the weighted average cost of capital (WACC), which we won’t get into for now. Instead, let’s focus on what makes up WACC – a risk-free component (usually the market return) and a risk premium taken from equities. All of this means that share prices are pretty good at letting you know what the overall market feels like, minus the risk factor attached to each firm.
Share prices are also ‘sentiment indicators’. Of course, it’s finance, and we really don’t want to bring emotions in here. This is already contested by behavioural economics, but let’s talk numbers for now. Consider that you have got an equity investment in XYZ firm in India and they’ve just ramped up production to meet increasing demand after uneasy market fluctuations in China. Your shares’ prices have now increased.
What’s next? You have added value to your investment – in simpler terms, extra cash! Assuming you dilute the investment and get the cash in hand, that’s definitely more spending potential. If you’re a pensioner, that’s a ticket to better living at retirement. You can even re-deposit this is in a bank account and get better interest and loans because of the increased amount. A real estate firm could get land at cheaper prices or replace old capital at lesser costs (check out Tobin’s q concept). This makes you happy, and this happened because of better market sentiments.
Remember we talked about the ‘risk premium’ factor included in share prices? This is an indicator that gives you a lot more information about how the market – and the company – is feeling. You also get to know if your gains (or losses) inspire your friends to invest (or stay away) from the stock market and what kind of profits will motivate them to take on the risk. This may seem pointless to you as an individual investor but it gives valuable insights to your friend’s portfolio manager and the firms on how in-demand their shares are.
Understanding the divergence
Essentially, it’s a mutually symbiotic relationship – your purchase of a Panasonic microwave oven pushes up the demand for their shares which again motivates your spending. If you’re an active investor, it’s important to train yourself to understand what counts as permanent and as temporary fluctuations. Always look out for what exactly drives or pulls the prices and you’ll get your answer easily enough. This means the dividend payments you get from your shares and the discount factor used to find out the present value of future earnings are equally important.
When you note fluctuations in the economy, it’s important to read up and find out which sector is playing a major role. That’ll help ease your tension about your shares in a construction company if the IT sector is causing disruptions. In fact, if the ground-level indicators are looking unsteady, say the IIP in your case, but the share prices look ready to go, it may indicate short-term problems that don’t have an effect on the sector’s future potential. All these indicators mix together to form a beautiful picture with an explanation for each movement.
What’s happening today?
In this context, we could tell you that the gross value added (GVA) of non-financial companies listed on the exchange has increased 14% y-o-y in the second half of 2020 and by 36% at the beginning of 2021. That doesn’t need to mean anything to you except for the fact that certain companies have been doing well during the pandemic and it seems like the rest of the economy hasn’t.
Here’s the deal, though. Certain companies are doing well because they are doing well – it’s like the situation with Infosys during the 2008 recession where they started hiring employees despite the overall economic situation. There’s been a significant turnaround in sectors of electric vehicles, real estate, and energy after key players capitalized on unexpected opportunities. In other sectors, it’s not been much of a hidden opportunity as declining costs, even with decreasing sales. RBI data for over 2700 non-financial companies show that their expenses have been reduced by at least 10 as compared to a 6% decrease in sales.
Despite these companies only accounting for a small percentage of firms in the economy, they are still indicators of future potential for the economy and shouldn’t be dismissed by looking at the general picture. The key challenge for the government – and unlocked potential for firms – will be the household sector, which will play a major role in the rejuvenation of demand within the economy. The tendency to increase savings will have an impact on investments and potential increases in corporate profits, especially since the latter can’t continue this momentum with the risk of increasing the fiscal deficit.
The pandemic and its effects are real. The optimistic side of this is that as firms show rigour during such times, it gives a quicker and more efficient boost to your demand for goods and services. The government recognizes this fact and you’ve seen their response to spur the economy through various initiatives and policies, both for consumers and firms. At this moment, your best move would be to watch the market and key economic drivers while analyzing these effects along with the stock price indicators to know what truly drives the rise.