The Great Divergence between stock prices and economic indicators

You’ve heard it many times already. The stock market continues to soar as economic prospects keep tumbling. The whole premise seems absurd and yet the divergence keeps compounding. So how does one explain this strange phenomenon?

The first explanation is the most obvious one. When people talk about the stock markets making new highs, they are not talking about the stock market. More often than not, they’re referring to the 30 or 50 stocks that serve as a benchmark to help people make sense of what’s happening. So yeah, Nifty 50 and Sensex 30 are at best a representation of what's happening in the broader market. It’s not the absolute truth. There are about 5000+ publicly listed companies that don't factor here. So you get the point.

In fact, stock prices of Small and Medium-sized companies have been taking a beating in the past year. So it’s not all hunky-dory everywhere. And even if one were to consider the 50 stocks that make up the Nifty 50 Index, there are about 10 stocks that have been chugging along despite the economic uncertainties. The other 40 haven’t been doing all that well. So this divergence is largely a result of the outperformance of a few extraordinary companies.

But the counterpoint is the earnings argument. Stock price performance is usually a function of the company’s future earnings potential. Ideally, you should see a company’s stock price grow at roughly the same pace as corporate earnings, at least in the long term.

But if one were to assess the earnings of the 50 benchmark stocks (Nifty 50) and compare it to their stock price, you see there’s a problem. While earnings have been growing at 3.8% for the past 6 years, the stock price has been growing at a whopping 11%. There’s a divergence here folks. And you can’t ignore it anymore.

One popular theory is that this is a direct fallout of the Mutual Fund Sahi Hai campaign. You tell enough people Mutual Funds are good for you and they’ll mindlessly keep dumping money into them. Once Mutual Fund Managers get a hold of all this cash, they’ll promptly go and buy shares of publicly listed companies irrespective of their assessment of a company’s future earnings potential. So the stock markets keep making new highs despite gloomy economic prospects.

But this can’t keep on going forever.

One fine day the public will finally come to terms with reality. And there will be redemptions in mass. People will scurry to move money out of their funds and get it to their savings account. The ensuing panic will further exacerbate the fall in stock markets and there will be pandemonium in the streets. So, a perpetual rise in stock price aided by the Mutual Fund Sahi hai campaign might not necessarily be the best reason to justify the divergence.

Another theory is that the stock market is a crystal ball that helps you peer into the future, unlike GDP numbers that only tell you about the here and now. So it's pointless to look at the current economic predicament and correlate them to stock price performance.

In fact, it is a well-known fact that the Indian Consumption story is truly well and intact. The young boys and girls you see around you today will become the hard-working men and women that build the nation of tomorrow. They will lift themselves out of poverty and assimilate with the burgeoning middle class. With improved well being, they will likely spend more and in turn aid the economy resulting in a virtuous cycle of growth. This increased spending i.e. consumption will then reflect in the growth of Indian companies and through it affect the stock markets. It's a story that can’t go possibly go awry. It even rhymes well.

Unfortunately, rhyming isn’t a good argument to justify the divergence. And academic research indicates that there is nothing automatic about the link from demographic change to economic growth. A burgeoning working-class population merely creates the potential for growth. Whether or not this potential is captured depends on the policy environment. Are the kids getting a solid education? Is the government facilitating the creation of new jobs to accommodate these young men and women? Is the country’s infrastructure supporting this new recipe for growth? If the answer is no, the consumption story will flat on its face. And this whole divergence between stock price performance and the economy will look like a complete farce.

And now you know why…

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