Is the Sensex obsession justified? Business Line 13th Nov 2019

A buoyant capital market does not always translate into improved investment activity in the economy

Tracking the stock markets has become an obsession, even though the movements in indices appear to be contrary to everything that they are supposed to reflect. Slow growth, low employment generation, sluggish consumption, stagnant investment etc are the realities of today. But stock indices spew optimism. Policymakers ensure that their announcements are in sync with the markets. The media spends several hours every day explaining how various stocks are going to move and news pages have experts conjecturing future peaks. The mood is almost always bullish and data is presented to show that the direction is potentially upward.

Just how accurate is the stock market, or the benchmark Sensex, in representing the economy to warrant such attention?

Representing market

The Sensex is believed to represent the market as most references are to this index. There are other indices which come into play, but the focus is always on the Sensex or Nifty and the new peaks of 29,000 (remember Everest?), or now, (beyond) 40,000. In fact, after every major announcement — such as the credit policy, Budget, bank mergers or housing finance packages — all eyes on the next day are on the Sensex to see if things have changed. Often, the impact of these announcements last for a single session, if not a few hours, and then things go back to normal. This raises a question on the obsession with these indices.

From the policymakers’ point of view, the logic is that when the capital market does well, companies are able to mobilise capital, which helps in investment and hence capital formation required for future growth. Therefore, the capital market is a kind of fulcrum for future growth and becomes the prayer book. But data has a different tale to tell.

During the last two years, when the GDP growth slowed down considerably, the Sensex moved from 29,620 (2016-17) to 38,672 (2018-19). There is talk of the GDP growth slowing down further this year to just about 6 per cent, if not lower, while the Sensex has crossed the 40,000-mark and is aiming for 42,000 next.

Certain critical variables have been listed in the table for the period 2010-11 to 2018-19 which should ideally be related with the Sensex. Growth in net profits refers to that of the 30 Sensex companies. The mutual funds and FPI flows in equity are absolute flows in rupees while the GFCF (Gross Fixed Capital Formation) rate is the capital formation rate expressed as a percentage of the GDP. The coefficient of correlation of change in the Sensex is mapped with these variables.

Varying relations

In terms of the coefficient of correlation, the range is between 0.25-0.32, with that of capital formation (GFCF) being negative. The highest coefficient is for net profit growth, which can be expected as it pertains to the Sensex companies.

The relation between Sensex movements and the GDP growth is quite interesting. While the coefficient of correlation is low, there appears to be a better relation in terms of direction of change. In two of the three years when the GDP growth rate slowed down, the Sensex also registered a lower change in growth rate. In four of the five years when the GDP growth rate improved, the rate of growth of the Sensex also increased. The only exception was 2015-16, when an increase in the GDP growth was met with a decline in the stock index.

The net profit growth of Sensex companies is probably the indicator that comes closest to the Sensex movements. Here, the coefficient of correlation is the best at 0.32 (which is not really high), thereby showing that high swings in Sensex have limited association with high changes in net profit. There are aberrations in 2011-12, 2013-14, 2014-15 and 2017-18.

A low correlation does imply that profit is not the sole driver of the 30 stocks; other factors, including expected earnings, the expansion plans of these companies, governance changes, quality of assets (if the company is a bank) etc, play a role as well. Therefore, profits can explain stock market movements only to an extent.

Capital formation rates

However, the surprise here is the link with the GFCF rate of the economy, where the coefficient is negative. This means that a high increase in Sensex is associated with low capital formation rates. Hence the argument that the stock market is linked with investment activity is negated.

As a corollary, the premise that giving incentives to the stock market helps in investment is not correct. The conundrum is easy to explain. The Sensex comprises only 30 stocks, of which 12 are in the banking and IT space, where there is limited investment in capital. The rest of the companies can invest, but have sectoral constraints.

The relation with mutual funds, where AUMs tend to increase, has not been very sharp; this is surprising. The same holds true for FPI investment flows into equities, where the correlation is low at 0.28.

Hence, even two entities that invest in the markets do not have a strong linkage here. In fact, 2015-16 appears to be the turning point for FPIs, which otherwise related well with the Sensex changes. Subsequently, the relation severed.

Therefore, while one can see some signs of relationship — albeit feeble — between the Sensex and other economic variables, there is reason to believe that even on a long-term basis there are extraneous forces driving the indices. There is definitely no set method to this madness.