Are the stock markets a leading indicator?
Stock markets are supposed to be forward-looking
because investors are interested not so much in
knowing how a company has performed in the past,
but how it will perform in the present.....
Stock markets are often taken as a leading indicator of the economy. They are
supposed to be forward-looking because investors are interested not so much in
knowing how a company has performed in the past, but how it will perform in the
present.
So, how well did the stock markets predict the turnaround after the dot-com
crash? India’s bellwether equity index, the Sensex on the Bombay Stock Exchange
(BSE), had reached a high of 6,150 points in February 2000, at a time when
manufacturing growth, according to the Index of Industrial Production, was
8.5%. The Sensex then continued to plunge, falling to a low of 2,594 in
September 2001. Manufacturing growth also declined, dipping to 3.5% in December
2000 and to a low of 1.4% in September 2001. Clearly, the crash in the stock
markets preceded lower manufacturing growth. That’s easily explicable, since a
market crash leads to a drying up of funding opportunities and acts as a brake
to growth.
But the market wasn’t such a good predictor of the upturn. Although the Sensex
did turn up after September 2001, it failed to post a sustainable rally and
even one-and-a-half years later at the end of April 2003, it was at 2,959.
Manufacturing growth too revived after September 2001, rising over 6% by July
2002 and above 7% by September 2002. As the chart shows, the Sensex did not
really predict the turn in the manufacturing index. In fact it was the other
way around, with manufacturing starting to grow faster before the Sensex turned
up.
But perhaps the manufacturing index is too narrow a gauge? Did the Sensex
predict an upturn in gross domestic product (GDP) growth? Not really. In the
third quarter of 2001-02, when the Sensex was at its lows, GDP growth was 6.8%,
thanks to excellent growth in services and agriculture. During the period, GDP
growth was at its lowest in the third quarter of 2002-03, when agricultural
growth was a negative 12.1%. (In fact, the reason for choosing manufacturing
growth rather than GDP as the indicator that should be correlated with the
Sensex is because agriculture is hardly represented among the Sensex
companies).
The Sensex at that time fluctuated around 3,000. And while GDP growth really
accelerated in the second quarter of 2003-04, rising to 9% and to 11.3% in the
third quarter, the Sensex started rallying only at the end of the second
quarter of that year. Once again, it’s difficult to assign any predictive
powers to the Sensex.
Perhaps the reason is because our markets are driven by foreign institutional
investment flows, which is why what matters most for their performance is
liquidity abroad.
Graphics by Ahmed Raza Khan / Mint
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