Stock Markets vs the Economy

What’s currently happening isn’t really a paradox.

We are in the midst of a global pandemic, struggling with public health and harsh economic shutdowns — and stock markets are rising. What’s happening? Aren’t stock markets supposed to be barometers of economies?

Stock markets are interactions between buyers and sellers — so if they rise, we need to understand why are more people buying than selling and vice-a-versa if stock markets are falling. As markets have become globalised and financial instruments have become more complicated, there can be myriad of reasons to understand this behaviour. In this article, we are just exploring the relationship with a key fundamental factor, GDP growth rate.

Let’s look at a couple of charts to understand.

In the charts below, I have compared stock market returns of a chosen index in three economies with the GDP growth rates (of the same year) of the same economy. The stock returns have been adjusted for inflation for a like to like comparison with real GDP growth rates.

There is almost no relationship between the two.

Let’s look at a second set of charts. Here the stock market returns have been compared to GDP growth rates of the next year.

There is a positive relationship between stock returns and GDP growth rates of next year.

What explains the behaviour in the above two sets of charts? Simply that markets are forward looking. Stock market investments are made keeping in mind the growth potential — hence the returns bear a positive relationship with expected GDP growth rates in the next year. Plus, when we value stocks, we discount them to the present period. As economies enter into lower growth or negative growth periods, interest rates are reduced to spur investments, this increases valuations of stocks and makes them attractive to purchase. Essentially you have the market price at which you can purchase a stock and the intrinsic valuation of that stock. As the valuation goes up, it becomes relatively cheaper to buy, so you are ready to purchase till prices increase proportionately and reduce the opportunity.

However, the above charts do not depict a very high correlation. Why might that be? Amidst other factors apart from fundamentals that affect this relationship, we need to acknowledge that the above relationships are wrt. the growth rates of domestic economies. As markets are increasingly more interlinked, domestic economy fundamentals are not the only factors explaining stock market returns.

Let’s look at how MSCI ACWI (consisting of both emerging and developed markets and all cap) reacts to world growth rates.

We see the same pattern when the take the world in aggregate — a very high correlation when the comparison is made with next year’s GDP.

What’s happening with India?

The trend in Indian markets is puzzling to say the least.

If I take data since 2009, then t correlation comes out to be 0.33 and t+1 correlation as 0.46. Hence, correlation is moving in the right direction but all we can conclude from here is that there is no comprehensible relationship of Nifty returns with India’s GDP growth rates. The following reasons might have a role to play:

Negative correlations in t can be an indicator of tactical portfolio shifts from developed markets to emerging markets and vice-a-versa. Decoding t+1 is a little tricky — my interpretation is a a general uptick in economic growth brings more equity investments overall and a fall leads to shift to fixed income.

Amidst all this, let’s look at how Nifty’s Price-Earnings ratio looks like —

Mean P/E starts with mean of the entire data range and then progressively gets rid of old observations and finally meets contemporary P/E at the end. Is Nifty P/E going to establish a new normal or is it over-valued? If it was supported by strong GDP growth projections, we could have talked about fundamentals more confidently, alas that doesn’t seem to be right. On the other hand, investment managers have an incentive to always hype the market because of how their variable pay is determined.

It’s always tricky to comment about the direction of markets, hence I’ll end this piece on this cautionary note about Nifty and leave you for your own interpretation.

References:

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