How the market reacts to policy changes

On May 17, 2004, the stock market went into a tizzy. The BSE Sensex and NSE Nifty fell by more than 17 per cent. This happened when the Indian economy was rolling at 8 per cent GDP growth, the macro- and micro-economic factors seemed strong, the corporate balance sheets were robust and the prospects for the coming quarters were encouraging.

The immediate cause was the election results, and the possibility of the UPA forming the government with the support of the Communist parties. While the fundamentals of the economy did not change, the sentiment had turned negative and market cap worth trillions of rupees was wiped out in just two sessions of the same day. It took months for the market to recover from the sensitivity shock.

Market sensitivity

Recently, one of the top team members of the current government’s think-tank — the NITI Aayog — made a public statement of a likely (definitive) change in policy with regard to the automobile sector. Even though the government’s policy is still under formulation and it was only the voice of one think-tank member, 5 per cent of the market cap of auto manufacturers — including ancillaries — was wiped out.

This was over and above the impact of a significant contraction in domestic demand for new motor vehicles. Road Transport and Highway Minister Nitin Gadkari and Finance & Corporate Affairs Minister Nirmala Sitharaman had to hurriedly issue statements to control the damage.

The capital market is very sensitive. It responds to the known-unknowns as well as the unknown-unknowns. It’s influenced by both fact and fiction. The intermediaries of the market are like birds, who discern the onset of a storm by the rustle of leaves and the whispering sounds of winds, and then rush for cover. The markets predict better than polls and other devices that are globally accepted (as stated by Wolfers and Zitzewitz, 2004). The efficient capital market hypothesis outlines that share prices fully and instantly reflect all information, fact or fiction.

The enterprise value of companies rises and falls more due to sentiments than by the fundamentals. If the market does not trust numbers, even those which are factually correct, the valuation of the company goes down and vice versa; the impact of sentiments.

The sensitivity of the market is the underpinning of an obligatory regulatory direction that every price-sensitive information has to be first announced to the market, so that all the participants are able to assess the likely impact on sentiments simultaneously and person/s privy to information do not inherit first-mover advantage. Pre- and post-market hours announcement is a well-merited concept.

The rationality of the market is often questioned. Morck, Shleifer and Vishny (1990) noted: “Fascinating as it may seem, the debate over market rationality is not consequential, if stock prices do not affect real economic activity.” We can debate till the cows come home about the rationality of the market or its consequences. That the capital markets are sensitive and market valuations have a proportionate impact on the economic activity has a broader universal acceptance.

Rising wealth effect

“Wealth effect” is an aspect of behavioural economic theory. It suggests that people tend to spend more as the value of their assets rises. The reasons for the change in the behaviour stems out of the increased confidence with a sense of reliability from the increasing value of wealth.

The rising wealth effect enhances the confidence to invest, spend, borrow and even take a risk. In fact, increases in consumer spending are directly correlated with increases in the value of stock portfolios.

Currently, the Indian economy is in a spot. The GDP growth has been decelerating quarter-on-quarter. The aggregate demand has substantially contracted. Equity indices are significantly lower. Global headwinds are strong. The geopolitical situation is nebulous. Oil prices are unstable. The Twitter posts of US President Donald Trump periodically add fuel to the fire which is melting the pot of the global economy.

A number of sectors and a large number of balance sheets are in distress. The entrepreneurs are finding it hard to pool in additional risk capital. The Centre has been at pains to announce ‘whatever it takes’ kind of measures to resurrect the economy. The impact, in particular of the once-in-decades (pleasant) surprise reduction in corporate income tax, has cheered the sentiments and stock price indexes have nearly wiped out all the past losses. A positive mood has been ushered in. The corporate voices are laudatory.

The decrease in the stock prices of a company and/or a sector has a negative wealth effect and adds to the challenges of raising resources. A number of entrepreneurs have pledged their holding to raise resources. They are receiving calls for margins and/or find their stocks being sold. The stories of sale of shares by the pledgees are resulting in disastrous consequences for entrepreneurs and enterprises are being reported almost every day.

A policy change can wreck the organisational design, business model and/or revenue structure of an enterprise or the industry as a whole. The inevitability of policy changes in a dynamic environment needs no debate. However, a change in policy or its stance has to be well graduated and its pronouncement sagaciously calibrated. Premature announcements, if ever necessitated, should be well thought-out and made with a clear understanding of the positive and negative impact on a segment and/or the market as a whole. And depending upon the broader environment, it has to be well-timed. Self-goals must be avoided in such a scenario.

There may be a need to test the waters by voicing the eventuality of changes in policy and/or stance. However, such endeavours have also to be crafted well. Policymaking and execution apparatus should be alive to the market sensitivity.

The writer is former chairman of SEBI and LIC

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