Does stock market mirror the economy?

Lokeshwarri SK | Updated on March 13, 2019 Published on March 13, 2019

Data over the last 4 decades show that major annual gains in the Sensex were always accompanied by strong GDP growth

It has often been observed that the economy could be sluggish but the stock market is surging or, conversely, despite a robust economy the stock market is listless.

Such short-term mismatch has led to the common perception that the stock market has a mind of its own and does not move in tandem with economic growth.

There are many arguments forwarded to support this view — the listed stock market universe is not really representative of the entire economy; the influence wielded by foreign portfolio investors on our market makes the stocks more sensitive to global developments; and stocks move on future expectation and, therefore, tend to discount the economic growth expectations in advance.

While these factors do influence the market, GDP growth too wields substantial influence on Indian stocks. We studied the GDP growth numbers since the 1960s and the annual change of the BSE Sensex since 1979 (year from which Sensex data is available), to see if there was any relation between the two data-sets. The results were quite interesting.

It’s a yes

Data over the last four decades indicate that outsized gains in the Sensex — annual return exceeding 50 per cent — have always coincided with major turning points for the Indian economy, which was accompanied by improvement in GDP growth.

For instance, the Sensex gained 93 per cent in the 1985, when the first set of reforms were rolled out , which included de-licensing of industries, abolishing price and distribution controls on construction material and introduction of the modified value-added tax. GDP growth improved to 5.25 per cent that year, higher than the 3.82 per cent the previous year. In 1988 too, the Sensex’s 50 per cent gain was aided by a phenomenal 9.6 per cent growth in GDP.

As the liberalisation of the economy began in December 1991 with the opening up of the economy to foreign investment, reduction in tariffs and deregulation of the markets, the stock market gave a thumbs-up with the Sensex surging 82 per cent in 1991 and 37 per cent in 1992.

The Sensex’s other large gains— in 1999, 2003 and 2009 — have also coincided with pick-up in growth compared to previous years. The last instance will be fresh in everyone’s minds when the Indian economy revived from the blow from the sub-prime crisis, thanks to large fiscal stimulus by the government. GDP growth was 8.48 per cent in 2009, compared with 3.89 per cent in 2008. The Sensex gained 81 per cent in 2009 after losing 51 per cent in 2008.

Years in which Sensex gained between 20 and 35 per cent were also accompanied by decent growth in GDP.

One explanation for the growth years boosting stock price is that corporate profits tend to improve as the economy picks up, giving a leg-up to demand. The converse could be true in a year of sluggish growth when lower consumption and investment could hurt the bottomline of companies as well.

Sensex’s loss-making years

While sharp gains in stock prices appear to be supported by and also driven by improvement in the Indian economy, deteriorating economic performance is not the sole cause behind market declines. The Sensex fared badly despite decent economic growth in 1995, 1996 and 2015.

While the market crash in 2015 was largely due to global sell-off due to Fed’s tightening and commodity price crash, domestic scams influenced market declines in 1995 and 1996.

But it needs to be noted that the only year in which the Sensex lost over 50 per cent — 2008 — witnessed severe contraction in economic growth.

The stellar returns by the stock market over the last four decades are also due to the fact that the economy was in an expansion phase in those years. While the Sensex delivered compounded annual growth of 20 per cent in the 1980s and 1990s as the economy grew from a low base, returns have since then slowed to 15 per cent between 2000 and 2010 and further lower to 7.7 per cent since 2010.

Projecting economic growth

It’s therefore apparent that in order to gauge the pace at which the market will grow over the long term it is important to understand the pace of economic growth.

PWC periodically publishes long-term economic growth numbers for major economies including India. Its report projects India to become the second largest economy by 2050, behind China. While India will remain among the fastest growing economies, its growth is expected to taper in the following decades — from 7-8 per cent until 2020 to around 5 per cent between 2021 and 2030 and to 4 per cent between 2030 and 2050. The lower income levels in India currently is expected to help it grow at a higher level than other economies until 2050.

OECD too projects Indian economic growth to be around 6 per cent in 2020; which will gradually reduce to around 3 per cent by 2050.

Implication for market returns

Most analysts tend to take the annual growth in stocks over the past 10 or 20 years to make projections of future growth.

That is far from ideal since the sharp expansion in stock prices in the last 40 years was mainly due to the economy being in the fast lane. As growth tempers down, stock price appreciation can also slow.

Given these considerations, stock price returns are more likely to be around 11 per cent this decade, considering the nominal GDP growth.

This can gradually taper down to around 5 per cent annual returns by 2050. Of course, there could be years of extraordinary returns or losses, if there is a big economic event.

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Published on March 13, 2019
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