The stock market index: a barometer of the state of the economy?

The performance of the stock market index (such as SENSEX, NIFTY or the Dow Jones) is often touted in media as a barometer of the current state of the economy, in particular of the growth of its Gross Domestic Product (or ‘GDP’). For instance, a government policy or the union budget may be perceived to be good for the country if the stock market index rises after their announcement. This conception, however, is misplaced. While there are good reasons why the state of the economy and its stock market are positively co-related, there are several instances where the GDP growth is sluggish (even negative), and despite that, the stock market continues to boom, and vice versa.

A stock market, as the name suggests, is a market where stocks of corporate equity are traded. To the extent that the equity prices accurately reflect valuation of the corporates, the stock index can be thought of as an index of how valuable a county’s stock of corporate assets is. This value, in theory, should depend on the expected stream of future incomes, suitably discounted to the present time. Economic policies that improve incomes today as well as in the future will raise the valuation of the corporate assets and therefore improve the stock index as well. Even a short-term boost to the country’s GDP will typically spur further investments and therefore may boost corporate incomes in the future. This increase in the future stream of incomes is then registered as an increase the stock market index.

A rising stock market can also have a direct causal effect on the state of the economy through the phenomenon called “the Wealth Effect.” Imagine a scenario wherein there is an influx of foreign investors in the stock market. This will raise the stock prices and will make all the citizens holding the stocks richer. This higher wealth will typically induce them to spend more and thereby boost the economic activity today.

Stock market performance may not tell you the full story!

However, there are reasons why the GDP growth and the performance of the stock index may diverge.

One reason for the divergence is rather obvious. An economy is much more comprehensive than its corporate sector. Particularly in less developed economies, where the informal sector (e.g. self-employed working class) as well as the public sector (i.e. the government-owned companies) form a big share of the economy, the livelihoods of a large fraction of its citizenry may be relatively disconnected from the corporate sector and its performance. Thus, certain economic policies, while profitable for the corporate sector, may be detrimental to the majority of ordinary citizens. Such policies may boost the stock index, but may reduce the GDP / GDP growth, and importantly, have an adverse impact on the overall welfare of the citizens. Similarly, if the stock market is dominated by foreign investors, the stock market might rise with certain policies that boost their returns on investment but that may be unrelated to the citizen’s economic conditions.

Another reason for the divergence is that some government policies may raise citizens’ incomes in the short-term but may have little impact in the long-term. As a hypothetical example, suppose that a flood or quake destroyed valuable corporate assets like oil rigs. This will register as a drop in the stock price due to lost future stream of incomes. However, this may also lead to immediate need for reconstruction work which would generate higher incomes in the short-term. Such a scenario may lead to a higher GDP growth in the short-term, but a sluggish stock market performance.

There is yet another reason why the stock markets sometimes move in the opposite direction to the economic news. This is to do with the expectations (realistic or otherwise). Think of a situation wherein the government is expected to unveil a new policy effective say the next financial year, and also suppose that such a policy is widely believed to be good for the economy. In this case, the “good news” gets built into the stock prices at the time of the announcement itself and, as a result, on the day of the actual implementation there is no discernable change in the stock index. In fact, at times, if the policy implemented was not as good as initially expected, the stock market can even crash on the day of the implementation!