Affinity between stock markets and GDP

This is one of the ongoing debates, on relationship between stock markets and macroeconomic growth, which has led to many studies being done by economists, analysts and financial policymakers but still not much has been concluded.

SENSEX REACHED a peak of 20,000 and then fell 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 number 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 agonises 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 being done by economists, analysts and financial policymakers but still not much has been concluded.

I can’t mention various studies done on this issue but here is 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 per cent, sensex has also posted similar gains. However, if we analyse 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 two 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 the present period there is a change in the trend, 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. No modern economy can exist without an efficient capital market. This is what has attracted international investors, who in recent years, have made India their favourite destination. Since our markets are now globally integrated, if we look at recent trends, for instance, when November IIP numbers were positive, still we were unable to lift the markets.