Affinity between stock markets & GDP

Sensex reached a peak of 20,000 and felled like a pack of cards to 10,000. What do these numbers suggest about macroeconomic growth of a country? Whenever there is news regarding some inflation numbers, IIP numbers markets react, but does this really matter, is there any evidence to it? Let’s find out:

Keynesian thesis states that “stock market is a casino”. However he also agnize that stock markets enable people with money to invest together with people who can put that investment to productive use.

This is one of the ongoing debates, on relationship between stock markets and macroeconomic growth, which has led to many studies done by various economist, analyst and financial policymakers but still not much is concluded.
I can’t mention various studies done on this issue but ill be here putting up a brief summary, on core theme of this debate.

If we trace the period between 1995 -2004, the CAGR (compounded annual growth rate) of real GDP and the BSE sensex shows a high degree of correlation, while real GDP has grown at 6.1%, sensex has also posted similar gains. However if we analyze the data more deeply, year on year examination gives a different picture. The outcome of this examination shows that, though Real GDP has shown a steady growth under the period of study, BSE sensex has been very volatile during the entire period. On year –on- year basis there seems to be no sync between the 2 factors.

However if one tends to consider growth in nominal GDP and corporate performance at the top-level, there it seems to be high degree of correlation. This is on account of the fact that GDP is aggregate of output of agriculture, industrial and services sector.

If we look at the trend stock markets are not always guided by fundamentals but also by sentiments. For instance, lowering of interest rates by the RBI (like until 2004) typically has an impact on the economy with a lag. But the signal that the RBI is reducing interest rates may prop up stock markets immediately and stock prices may react much faster.

However in present period there is a bit change in the trend, this due to the fact that Indian Economy is now more integrated with global world than before. At worldwide level capital markets evince attributes of perfect market with no or acceptable entry barriers, large number of buyers and sellers, absence of, or very low, transaction costs, tax parity, and free trading.
To attract international investments, countries compete with each other and promote their capital markets with savvy sops and policy announcements. It is in fact a reality that no modern economy can exist without an efficient capital market. This is what have attracted international investors and in recent years have made India their favorite destination. Since our markets globally integrated if we look in recent time trends, for instance when November IIP numbers came positive, were unable to pick up the markets, however most of the times we get to hear that markets are beaten due to weak global cues , or any uncertain event at international level have an effect on our markets.

The crux of the issue is that economy goes through business cycles of recovery, boom, slowdown and recession. Stock market also moves on the similar pattern. For instance if India GDP grows at 10% in one year, the sensex may not gain similar percentage during the same year. However, the relationship may hold true over the longer-term. It may be stated that the state of the economy has a bearing on the share prices but the health of the stock market in the sense of a rising share price index is not reflective of an improvement in the health of the economy.
In summing up the basic purpose of all studies done is to find out relation between economic growth and stock markets. Though it can’t be neglected that stock market directions are based on fundamentals in long term, however these assumption may turn out to be dangerous for investors in short term. Therefore all analyst advice to go for investment in stocks with a long term view.