The Link between Economy and Market

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The Link between Economy and Market

Conventional wisdom says the market is a reflection of economic activity and should move in tandem. The reality is showing the fragile link between them. Many who are trying to make sense of stock market performance with economic activity are for a crude shock. On one side we are witnessing a deluge of negative news coming on both economic health of the country and personal health of individual and at the same time stock market seems to be oblivious of these data points and are rising one way. We all know the economy is in a terrible state, thanks to the coronavirus. Even before this pathogen attacked us, our economy was not in the pink of health. This is the third year in a row that India’s GDP growth has declined. From a high it reached in FY16 when it recorded GDP growth of more than 8 percent, it has seen a consistent and continuous decline. Even against this background, we see frontline equity indices in India touching their lifetime high.

If we see a graph showing the quarterly GDP growth rate and movement of BSE 500, which covers more than 90 % of the market cap of companies listed domestically, it clearly shows there is a similarity in directional movement, however, they do not move exactly in the same proportion. In fact, the correlation between the GDP growth and BSE 500 growth has been around 0.33 for the last eight years. It is true that they move in a similar direction in the long run but it may not be true in the short run. There are factors beyond the economic activity that shapes the movement of the equity indices.

This relation holds true even between GDP growth and growth in earning per share (EPS) of Nifty. Historically, we have seen that the relationship between Nifty earnings growth and India’s GDP growth has been rather weak. Although there is a high correlation in the direction that is they move in the same direction when the economy is accelerating. Nifty growth also accelerates, the correlation is more than 0.9, however, in terms of magnitude, the correlation is below 0.25.

Why GDP and Nifty do not move together? First, you should understand that Nifty stocks are not a great barometer of economic activity in the country, which is commonly perceived. This is because the constituents of frontline equity indices are the companies with the largest market cap and generally the largest profitable too. And the choice of stocks going into indices depends a lot on which sectors are seeing strong earnings visibility and favoured by the markets. Hence, the major sector of an economy with good earnings, however, with lower price to earnings may not be represented in the benchmark indices. However, they have larger say in the GDP number. Therefore, indices movement largely reflects what an investor is thinking about the sector and company and how are they going to perform going forward.

Besides as the world economy is getting more and more integrated, the financial performance of companies is not entirely dependent upon the domestic economy. This is true even for Indian companies. According to a study done by a brokerage firm of how much of Nifty stocks’ topline comes from domestic sales (the rest being overseas/exports) shows it is declining. While there was high dependence on the domestic economy for Nifty stocks in the 2000s, that link broke significantly in the 2010’s decade. This was due to the higher weightage of IT services and pharmaceutical sectors into the Nifty. It is well known that sector from these companies draws their revenue and profits a lot on the external economy than the domestic economy.

In the last few years, the rise of domestic-focused financial stocks (including NBFCs) and the consumer sector has led to some resurgence of dependence on the domestic economy for Nifty sales. However, at less than two-thirds of sales from the domestic sector, we cannot expect them to mimic domestic economic activity and doubt if it can be called a good barometer of economic activity in the country. Yes a broader study of an index like BSE500 may show some strong correlation.

In addition to this, we also see that the share of Nifty stocks within the economy is also falling – their share of GVA (gross value added) has fallen from 2.8% in 2010 to 2% in 2020. This means that the influence of these companies in the domestic economy is not so strong and falling and hence we can expect that Nifty and the economy can move in the opposite direction.

Moreover, it is highly likely that these 50 stocks may endure the hit from pandemic far better than the rest of the economy that is in shambles. Overall, we conclude that investors should delink top-down economic views from market earnings indicators like the Nifty EPS where a bottom-up approach is best suited.

About the author: IE&M Team
IE&M Team
Indian Economy & Market is an Indian media and information platform producing data-backed news and analysis on all the vital elements at the intersection of the economy, stock markets, mutual fund, insurance, commodities, currency, technology, startups and business.

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