Ever since the stock market began recovering from the March lows, there has been a glaring disconnect between the devastating impact of Covid-19 on the economy and the celebratory mood of the stock market. 18 months later, that disconnect is as deep as ever. The virus continues to plague the economy and the well-being of millions of people while the market marches higher.

With India’s premier benchmark index Nifty touching 18k, that disconnect is as deep as ever. I noticed a lot of people on Twitter and other online forums complaining that this is a bubble because the economy isn’t doing nearly as well as the broader market indices.

In this blog post, I’ll try and objectively explain how this notion of the markets and the economy being correlated is actually a myth, not just in India but globally. The Indian economy has altered so radically over the past decade that the Nifty no longer captures the development of the economy.

Understanding what people mean when they refer to the economy or the stock market?

When they say economy, no indicator is more closely watched over time than GDP growth. GDP or Gross Domestic Product measures the total value of all goods and services produced in the country. It reflects all of the consumption that has occurred in both the public and private sectors.

The Stock Market isn't a measure of the amount of goods and services that people are buying. When you hear “experts” on morning shows talking about the Stock Market, most of the time what they’re referring to is the indices that capture the broader market. (Those would be the Nifty or Sensex for India and S&P500 or DJIA for the US).

The market is not the economy. Its job is to tabulate investors’ consensus view about the future of publicly traded/listed and not privately held/unlisted companies. It’s important to distinguish between the two, not only as a matter of basic financial literacy but also because the market is often uncertain about what’s happening in the broader economy.

The stock market is linked to profitability of the underlying companies, not growth of countries. There is a famous saying:

Stocks are slaves of earnings

A decade ago, many investors predicted that the emerging markets would deliver higher returns to investors due to their high growth rates. However, that has not happened. Why is that? It’s because the stock market does not care much about growth. India is and will be a high growth country. But it has not delivered in terms of corporate profits.

On the other hand, America grows at a much lower rate but has delivered terrific returns to investors. This is because American companies have delivered high profits in the last decade. The stock market reacts on profitability, not growth.

Over the past decade, Nifty’s earnings have not only grown at a much slower pace than the Indian economy, they have also trailed the S&P500’s earnings growth by a country mile (although the Indian economy is growing much faster than the US economy).

In the US, the years since the 2008 financial crisis are just the latest example. The stock market has performed far better than usual since the crisis, mostly because corporate America has enjoyed huge profits. Meanwhile, the economy has struggled to grow, leaving lots of Americans behind and widening the gap between rich and poor. Covid-19 has further deepened that divide. If you looked only at the market, you would hardly know anything was amiss.

Research

An analysis by Prof. Jay Ritter of the University of Florida that ran from 1900 through 2011 for developed-markets countries, and 1988 through 2011 for emerging-markets countries, does not confirm this instinctive connection. It highlights that in the long run there has been a negative correlation between economic growth and stock market return in developed as well as in emerging (developing) markets.

A similar study was done by Jeremy Siegel, Professor of Finance at Wharton School, from 1970 through 1997, in which he compared the stock returns and economic growth among the developed countries. He found that except for Singapore, over the past 27 years there has been a negative correlation between economic growth and dollar stock returns.

In theory, technology along with land, labour, capital and enterprise contributes to the growth in the economy. However in 1999, Warren Buffet argued that in the long run in a competitive economy, benefits from changes in technology accrue to the consumer and not necessary to the shareholders. He cites examples of car makers, manufacturers of radio, television and aircraft, where the industry has grown apace and has contributed to the economy but investor returns are poor. According to him it is important to pay attention to the competitive advantage of any given company and above all the durability of that advantage.  

In the Indian context, the Telecom sector between 2005-15 (before Jio entered) serves as an illustrative example of this dichotomy. During those 10 years, the telecom industry saw a subscriber base addition of more than 40% CAGR, and yet the underlying stocks didn't grow nearly as much. (Vodafone India's share price CAGR was in the low single digits and for Bharti Airtel it was ~10%).

Why the dissociation?

There’s nothing unusual about it, the market and the economy have rarely moved in tandem, and for good reasons:

Markets look into the future

After the Lehman crisis in 2008, the markets had reclaimed their previous levels by 2009, but the economy recovered in 2011/12. We saw the same phenomena last year in 2020. Markets tend to be forward-looking, and investors who think a stock will deliver high performance in the future will value stocks to be higher. Therefore, an expected recovery in the economy in the future will raise prices in the stock markets today, and an expected crisis in the future will lead to falling prices today. The stock market is buoyed by investor optimism about the economy in the future.

Companies are increasingly global in nature

According to Prof. Siegel, one reason for stock market returns not to follow GDP growth may be progressing globalisation and the fact that multinational corporations play an increasingly important role in the economies. In other words, many corporations derive a good chunk of their profits from international operations, which are not dependent on domestic operations. They are less tied to the domestic economy today than they were 10-15 years ago. So traditional metrics comparing market and GDP may not be relevant today as businesses become global.

For markets such as the US - this difference can be huge. For example, 40% of the sales of all the companies in the S&P500 tend to be from outside the US.

Specific large sectors such as IT in India are primarily international. Performance of Tata Motors is exposed to operations of JLR, its 100% subsidiary, which has its operations outside India. Its profit forms a large part of the profit pool for the parent. In this case JLR’s operations outside India will not add to the Indian economy, but its profit contribution would impact Tata Motors share price.

Broader Indices don’t reflect the whole market (fairly)

The way indices such as Sensex and Nifty work is that the larger the company, the more significant the impact on the index. Today in India - the top 10-20 companies have a disproportionate effect on the price of these common indexes. So even though the economy is struggling, a positive earnings trend in the top 20 companies will make the stock markets act differently. So today, the stock markets are more of a reflection of the top 20 companies in India than it is of the economy. The same goes for the US - where the top 10-20 companies are responsible for most of the index today.

Sectoral Dominance

There is another potential explanation for the disconnect identified above: Sectoral dominance. The stock market’s relative stability right now is coming mostly from only one or two sectors. The make-up of the economy and the stock market is different today.

Nifty and Sensex are dominated by sectors such as financial services, telecom, and IT, which may not represent the Indian economy. Most of India’s employment tends to be in Small and medium-sized enterprises (SMEs), manufacturing, trading, agriculture, which has a minuscule representation in the stock market.

Nifty is not as vibrant and young as it used to be. It no longer reflects the dynamism of the Indian Economy. If you look at the sector wise composition of India's GDP and the Nifty index, they're very disconnected. The Nifty overweights sectors like financial sectors significantly, relative to GDP. Power, Construction, Metals, Telecom, Real Estate and Oil & Gas accounted for roughly 30-35% of the Indian economy. And yet these companies account for two-thirds of the companies in the Nifty leaving little room in the index for the more vibrant sectors of the economy.

Nifty underweights sectors like technology. That's because these type of companies, like technology for example, no longer rely on the stock market's funding. Private Equity and VCs are taking away the best investment opportunities in India. They're driving economic growth, but they're not driving earnings growth.

The stock market is left with this old fashioned industrials, like metals, mining, real estate, PSUs. The over-representation in the Nifty of the capital heavy sectors of the economy is therefore a key reason for its sluggish performance. Nifty's 10 year earnings CAGR is close to 0%. For 5 years it's around 2-3%.

Similarly, in the US - the index is dominated by tech stocks (FAANG companies), which form a small part of the overall economy but a large part of the stock market. In the US, the rise in stock prices is much stronger for these technology companies than it is for most other companies. In fact, the disconnect is extremely wide at the moment. It’s not that the economy is doing well: rather, it’s that high-tech companies like Apple, Google, and Microsoft are doing very well. They have roughly five high-tech companies now accounting for almost a quarter of the S&P 500. Stocks are going up partly because the stay-at-home economy favours the products and services that these companies offer.

Unlisted players

Indices don't reflect private (unlisted) businesses or other important parts of the economy. Not all the companies/enterprises are listed on the stock exchange. SMEs make up a huge part of the Indian economy and contribute largely to the GDP, but most of them aren't listed.

Over the last five years, the Nifty’s performance has increasingly diverged from India’s nominal GDP (after faithfully tracking it for much of the preceding decade). This in turn suggests that significant drivers of the Indian economy are no longer in the listed market. For example, taxi aggregators (Ola, Uber), online retailers (Flipkart, Amazon), hotels other than Taj, Oberoi and Lemon Tree, etc – basically most of the things that affluent India buys beyond FMCG and apparel – is no longer in the listed market. Even large FMCG corporations like Amul, Parle, Haldiram's, etc that contribute a huge amount to the nation's GDP remain unlisted. These companies are able to access capital at low cost without entering the stock market and therefore their contribution to GDP is not reflected in the stock market. If, as the Indian economy matures, the unlisted world continues to provide capital at lower cost than the listed market then the gap between GDP and market cap will widen further. The US stock market is doing the opposite – US companies are increasingly generating their profit growth from Emerging Markets. As a result, the S&P500’s earnings are growing much faster than the American economy.

Conclusion

So what can be done to clear up the confusion around the market and the economy? Media outlets, for one, can make economic data as visible as stock tickers, granting that watching stocks bounce around is far more exciting. Economists and financial pundits can be more careful about using the market as a proxy for the economy, and push back when politicians do it. But perhaps the best way is to just say it plainly: The stock market doesn’t care about the economy.

I'm not a SEBI registered investment advisor and I don't have a background in Finance. I'm just a random guy on the internet who is curious about the inner workings of the economy. The contents in this article are based on my readings on various forums & financial articles, and my not so well-formed opinions about how the the economy & markets work based on the knowledge & experience I've gathered investing in them since 2018 (which is an extremely short amount of time if you're wondering :p). So please take all of this with a grain of salt.