Why is the stock market going up when the economy is going down?

The total collections of the goods and services tax (GST) between March and July stood at Rs 2.73 lakh crore. This is 34.5% lower than what the government earned during the same period in 2019.

The stock market index Nifty 50 has rallied by 53% to 11,648 points between March 23 and August 28. It had touched this year’s low of 7,610 points on March 23.

So, what’s the point in comparing the Nifty 50 with GST collections? The GST is basically a tax on consumption. If the GST collections are down by more than a third, what that basically means is that private consumption is down majorly.

When consumption is down, the company earnings are bound to take a beating. Take the case of two-wheelers and cars. When people don’t buy as many of them as they used to, their production takes a beating. When that happens, it has an impact right down the value chain. It means lower production of steel, steering, glass, tyres, etc. A lower production of tyres means a lower demand for rubber.

A lower production on the whole means lower demand for power. Industrial power largely subsidises farm power and home power (where power is stolen). If industrial power consumption goes down, the losses of state electricity boards go up. When this happens, their ability to keep paying power generation companies goes down. When these companies don’t get paid, they are in no position to repay loans they have taken from banks. So, the cycle works.

Many people buy two-wheelers and cars on loans from banks and non-banking finance companies. When the buying falls, the total amount of loans given by banks also comes down. When banks don’t get enough loans, they need to cut the interest rate on their fixed deposits.

When this happens, people who are saving towards a goal, need to save more. This means they need to cut down on their consumption. Further, people who are largely dependent on interest from bank deposits will see their incomes fall. This means they need to cut down on their consumption as well.

This cycle will also lead to a fall company earnings. A Business Standard results tracker for 1,946 companies reveals that the sales of these companies for April to June 2020 were down 23.1% in comparison to the same period in 2019. The net profit for these companies was down 60.8%.

The stock market does not wait for things to happen. It discounted for this possibility and the Nifty fell by 32.1% between end February and March 23. The market was adjusting for an era of falling company earnings. But it didn’t stay at those low levels and has rallied by more than 50% since then.

The trouble now is that the valuations are way off the chart. The price to earnings ratio of the Nifty 50 index, as of August 28, stood at 32.92. This means that investors are ready to pay close to Rs 33 for every rupee of earning for stocks that make up the Nifty 50 index. Such a level has never been seen before. Not during the dotcom bubble era and not even during early 2008 when the stock market rallied to its then highest level.

Why has the stock market jumped as much as it has? Does this mean that the company earnings will jump big time in the near future? Not at all. The covid-induced recession is not going to go anytime quickly. Also, the pandemic is now gradually making its way into rural India.

So, why is the stock market rallying? The Western central banks led by the Federal Reserve of the United States, the American central bank, have printed a lot of money post February, in order to drive down interest rates and get people and businesses to borrow and spend. The Federal Reserve has printed more than $2.8 trillion between February 26 and August 5. Some of this money has made it into India.

During this financial year, the foreign institutional investors have net invested a total of Rs 83,682 crore into Indian stocks, after going easy on investing in India over the last few years. This is clearly an impact of the easy money policies being run in much of the Western world.

Further, the participation of the retail investors in the stock market has increased during the course of this year. Between December 2019 and June 2020, the number of demat accounts has gone up by 39 lakhs or 10% to 4.32 crore accounts. In fact, between March end, after a physical lockdown to tackle covid was introduced, and up to June, the number of demat accounts has gone up by 24 lakhs.

The latest monthly bulletin of Securities and Exchange Board of India, the stock market regulator, points out: “We have seen a huge surge in participation of retail investors in the equity market in the last few months. The fact that there is also a surge in opening up of demat accounts suggests that many of these retail investors are perhaps first time investors in the stock market.”

With after tax return on bank fixed deposits down to 4-5% when inflation is close to 7%, these investors are coming to the stock market, in search of higher returns.

The question is, with the stock market at all time high valuations, will their good times continue? Or once the dust has settled, is another generation of investors ready to equate stock market investing to gambling? On that your guess is as good as mine.

This article originally appeared in the Deccan Herald on August 30, 2020.

Retail Investors or Chickens Waiting to Get Slaughtered in the Stock Market?

Every year, for the last eight to ten days of the year, I try and take a reading holiday. In this time, I try and read a lot of crime fiction which I absolutely love, and non-fiction, which I would normally not read.

This year was no different. I took my regular reading holiday and ended up reading a fairly interesting set of books. All this set me thinking about the current state of the stock market in India. But before I get to that, let me describe what provided the cue for that.

One of the books I read was titled Police at the Station and They Don’t Look Friendly. This is an Irish crime fiction book written by Adrian McKinty. The lead character in this book is named Detective Sean Duffy, who somewhere in the book says: “I went out to the BMW and checked underneath it for bombs. No bombs but I’d always keep checking. As a student I’d listened to an aged Bertrand Russell’s thoughts on the fate of turkeys being fattened for Christmas, the turkeys subscribed to the philosophy of inductivist reasoning and didn’t see doomsday coming. I will.”

The book is set in the late 1980s, when the Irish Republican Army used to be a terror in Ireland. Hence, Inspector Duffy, was in the habit of checking for bombs, every time he drove his car. In the paragraph quoted above, Duffy also talks about the British mathematician and philosopher Bertrand Russell, turkeys and inductivist reasoning. What does he mean?

This is where things get interesting and need some elaboration. Another interesting book that I happened to read was Everything and More-A Compact History of Infinity by the American writer David Foster Wallace. The book is a fascinating history of the mathematical concept of infinity, which anyone without any background in Mathematics can also read and enjoy.

Among other things, Wallace in this book also discusses the principle of induction (the same as inductivist reasoning which Inspector Duffy talks about). As he writes: “The principle of induction states that if something x has happened in certain particular circumstances n times in the past, we are justified in believing that the same circumstances will produce x on the (n+1)th occasion.”

Wallace then goes on to say that the principle of induction is merely an abstraction from experience. He then goes on to give the example of Mr Chicken (you can replace it with Mr Turkey and come up with what Inspector Duffy was talking about). As Wallace writes: “There were four chickens in a wire coop of the garage, the brightest of whom was called Mr Chicken. Every morning, the farm’s hired man’s appearance in the coop area with a certain burlap sack caused Mr Chicken to get excited and start doing warmup-pecks at the ground, because he knew it was feeding time. It was always around the same time t every morning, and Mr Chicken had figured out, (man + sack) = food, and thus was confidently doing his warmup-pecks on that last Sunday morning when the hired man suddenly reached out and grabbed Mr Chicken and in one smooth motion wrung his neck and put him in the burlap sack and bore him off to the kitchen.”

So, what happened here? The chickens in the coop received food at a certain point of time every day. This led them to believe that the future will continue to be like the past and every day they will continue to receive food. Or to put it mathematically, just because something had happened n times, it will happen the (n+1)th time as well.

But what happened the (n+1)th time was that the chickens were killed to be cooked as food. As Wallace puts it: “The conclusion, abstract as it is, seems inescapable: what justifies our confidence in the Principle of Induction is that it has always worked so well in the past, at least up to now.”

This is a concept that Nassim Nicholas Taleb also explains his book Anti Fragile“A turkey is fed for a thousand days by a butcher; every day confirms to its staff of analysts that butchers love turkeys “with increased statistical confidence.” The butcher will keep feeding the turkey until a few days before thanksgiving. Then comes that day when it is really not a very good idea to be a turkey. So, with the butcher surprising it, the turkey will have a revision of belief-right when its confidence in the statement that the butcher loves turkeys is maximal … the key here is such a surprise will be a Black Swan event; but just for the turkey, not for the butcher.”

As Taleb further writes: “We can also see from the turkey story the mother of all harmful mistakes: mistaking absence of evidence (of harm) for evidence of absence, a mistake that tends to prevail in intellectual circles.”

So, I guess by now, dear reader, the link between chickens (or turkeys for that matter) and the principle of mathematical induction must be very clear. But what is the link with the stock market investors? The Indian stock market investors since November 2016 have been like chickens and turkeys, where they have been well-fed in the form of good returns. And this has led them to assume that the good returns will continue in the time to come. At least, this is the feeling that I get after having spoken at a few investor conferences lately, and yes, the data suggests this as well. The logic as always is: “This time is different”. But is it?

Let’s look at some data which clearly shows that the stock market is clearly in a bubbly territory now. Figure 1 plots the price to earnings ratio of the Nifty 50, which is a reasonably good representation of the overall stock market, from January 1999 onwards.

Figure 1, clearly tells us that the price to earnings ratio of the stocks that constitute the Nifty index are at an extremely high level. The highest price to earnings ratio in the current rally was on December 26, 2017, when it touched 26.97. This means that investors are ready to pay Rs 26.97 for every rupee of profit that the Nifty companies make.

Figure 1: 

At the beginning of the year, the price to earnings ratio of Nifty was around 22. From there it has touched nearly 27. This basically means that while the price of the stocks has gone up, the net profit that these companies make, hasn’t been able to rise at the same pace. The average price to earnings ratio since January 1999 has been 19.1. This also suggests that we are clearly in bubbly territory now.

There are 35 other instances of the price to earnings ratio being higher than the 26.97. All these instances were either between January and March 2000, when the dotcom bubble and the Ketan Parekh stock market scam were at their peak, or between December 2007 and January 2008, when the stock market peaked, before the financial crisis which finally led to many Wall Street financial institutions going more or less bust, broke out.

The highest price to earnings ratio of the Nifty was at 28.47 on February 11, 2000. As is clear from Figure 1, after achieving these peaks, the stock market fell dramatically in the days to come. As of March 31, 2017, the market capitalisation of Nifty stocks made up 62.9 per cent of the free float market capitalisation of the stocks listed on the National Stock Exchange. The point being that it is a good representation of the overall


Lest, I get accused of looking at only the best stocks in the market, it is important to state here that price to earnings ratio of other indices is also at very high levels. Take a look Table 1.

Table 1:

Name of the indexPrice to Earnings Ratio as on January 1, 2018
Nifty 10028.1
Nifty 20030.32
Nifty 50032.36

Source: Ace EquityThe price to earnings ratio of the indices in Table 1 is at a five-year high. Table 1 tells us very clearly that the price to earnings ratios of the other indices, which are made up of small as well as midcap stocks, have gone up at a much faster rate than the Nifty 50.

This isn’t surprising. Every bull run sees the small and midcap stock rallying much faster than the large cap stocks which constitute the Nifty 50. And given this the fall as and when it happens, always leads to greater losses.

Investors, especially retail investors, continue to bet big on the stock market. Let’s look at Figure 2, which basically plots the total amount of money coming into equity mutual funds (i.e. net investment, which basically means the total amount of new money invested in equity mutual funds during a month minus the total amount of money that is redeemed by investors from these funds).

Figure 2: 

Figure 2 basically plots the total net investment in equity mutual funds since December 2012. As is clear from Figure 2, as the stock prices have gone from strength and strength and their price to earnings ratios have gone up, the net investment in equity mutual funds month on month has gone up. In November 2017, Rs 1,95,080 million of net investment was made in Indian equity mutual funds.

This is an excellent example of retail money coming into the stock market, after they have rallied considerably. Will the stock market fall from here? History suggests that the Nifty 50 price to earnings ratio has never crossed a level of 28.47, and we are very close to that level. Having said that I do need to state something that the economist John Maynard Keynes once said: “Markets can remain irrational longer than you can remain solvent”. So, timing the market remains a tricky business.

Also, it is worth remembering here, that while the fund managers would like you to believe that this time it is different, it never really is. And when markets crash after such highs, they do so very quickly.

Let’s take a look at what happened in 2008. Take a look at Figure 3, which basically plots the closing level of Nifty 50, between November 2007 and December 2008.

Figure 3: 

On January 8, 2008, the Nifty 50 reached a level of 6,287.85 points. More than 9 months later on October 27, 2008, it had fallen by nearly 60 per cent to a level of 2,524.2 points. Given that the stock market investors have a very short memory, Figure 3 is a very important chart. This happened just ten years back.

Of course, the retail investors who come in at the peak, get hurt the most, during such falls. What all this suggests very clearly is that the retail investors in the stock market are essentially chickens who are currently being fattened with good food in the form of returns. They are also assuming that this will continue. But what history tells us very clearly is that they are waiting to be slaughtered. And given that they will be caught unawares as and when the stock market falls, the bloodbath that follows will be ‘as usual’ extremely deadly.

Vivek Kaul
Vivek Kaul

This originally appeared in the Vivek Kaul Letter dated January 4, 2018. It was also published on Equitymaster on January 9, 2018.

Nifty 10,000: Coming soon at a stock market near you

bullfightingVivek Kaul

It is that time of the year when the stock market analysts get busy predicting what levels do they see Sensex/Nifty reaching during the course of the next financial year.
First off the blocks this year are Gautam Chhaochharia and Sanjena Dadawala of UBS Global Research, who have predicted that the NSE Nifty will touch 9,600 points by the end of 2015. As I write this, the Nifty is trading at around 8375 points. Hence, the UBS analysts are basically talking about the Nifty index, rallying by around 15% over the course of the next thirteen and a half months by end 2015.
The prediction of 9,600 points has been arrived at by making certain assumptions, including the expectation of earnings of companies growing by 15% during the course of the next financial year (i.e. the period between April 1, 2015 and March 31, 2016).
Over the next few weeks you will see a spate of analysts of making such predictions. And it won’t be surprising if someone comes up with a Nifty target of 10,000 points or more. For one, saying that Nifty will touch 10,000 points is inherently more sexier than saying Nifty will touch 9,600 points. A big round number always sounds so much better.
Further, Nifty at 10,000 points will be around 19.4% higher than the current level of 8375 points. It has rallied by 32.6% during the course of this year (from January 2014 to November 13, 2014). Hence, a rally of 19.4%, assuming that Nifty will touch 10,000 by end 2015, sounds pretty reasonable.
Nevertheless, the question is how do these analysts know? John Kenneth Galbraith explains this in his book 
The Economics of Innocent Fraud. As he writes “The fraud begins with a controlling fact, inescapably evident but universally ignored. It is that the future of economic performance of the economy, the passage from good times to recession or depression and back, cannot be foretold. There are more ample predictions but no firm knowledge.”
And why is that ?“There is the variable effect of exports, imports, capital movements and corporate, public and government reaction thereto. Thus the all-too-evident-fact: The combined result of the unknown cannot be known,” writes Galbraith.
Nevertheless, these predictions serve a useful purpose. They tell people what they want to hear, especially during a bull market, when share prices are going up and people are inherently optimistic about things. As Galbraith puts it “The men and women so engaged[i.e. the ones making the predictions] believe and are believed by others to have knowledge of the unknown; research is thought to create such knowledge. Because what is predicted is what others wish to hear and what they wish to profit or have some return from, hope or need covers reality.”
The stock market rally this year has been more about “easy money” from abroad coming into India, rather than any fundamental improvement in economic activity. Since the beginning of the year (and upto November 13,2014) foreign institutional investors have made a net investment of Rs 67,359.4 crore into the Indian stock market.
This has largely been on account of Western central banks maintaining low interest rates. Hence, foreign investors have been able to borrow money at low interest rates and invest it in the Indian stock market. The inflows have been particularly strong since May, when Narendra Modi came to power. Since May 2014, Rs 35,545.7 crore has been the net investment made by FIIs in India.
The basic point is that in an environment where easy money is essentially driving up stock prices, predictions are more about understanding investor psychology than the underlying fundamentals of the market.
An excellent analogy here is that of Henry Blodget, who used to work as a senior analyst with
the Wall Street firm CIBC Oppenheimer, in the late 1990s. In October 1998, Blodget brought out a report on Amazon.com. In this report he had predicted that the stock would go past $150 in a year’s time. He had also added in that report that the stock was worth anywhere between $150 and $500. At that point of time, the stock was quoting at $80. The stock raced past Blodget’s one-year target within a few weeks, so huge was the flow of money into the stock market.
His sales team then began to pester him for a new target. By December 1998, the price of the Amazon stock had crossed $200. As Maggie Mahar recounts in Bull!—A History of the Boom and Bust, 1982–2004 “Privately, he[Blodget] was confident that Amazon would hit $400—he just didn’t know if he had the balls to say it. But as his very first boss on Wall Street had told him, “You’re not a portfolio manager—you‘re not trying to sneak quietly into a stock before someone else sees it. You’re an analyst: your job is to go out and take a position.”
And that is what Blodget did. He took the position that Amazon would hit $400 within a year’s time. There must have been hundreds of other analysts on Wall Street who could have said the same thing. It was just that Blodget had the balls to say the right thing at the right time. He told the stock market what it wanted to hear.
Blodget put out his recommendation of Amazon hitting $400 on December 16, 1998. Within minutes, his forecast was traveling around the world. A Bloomberg reporter got a tip and put out the story. Soon, CNBC picked it up. And in no time, the recommendation had hit the chat boards across the various internet sites. And once that happened, the stock simply went through the roof. Amazon, which had closed at a price of $242.75 on December 15, 1998, closed 19 percent higher at $289 on December 16, 1998.
After this, the price of Amazon went on a roll. The stock was split in early January 1999, and the price crossed the $400 level that Blodget had predicted in March 1999, in split adjusted terms. Blodget got the investor psychology right. At some level, Blodget understood that he was in the midst of a stock market driven more by emotion and momentum. Hence, more than the price of the stock, he had to predict investor psychology and where that could take the price.
The Indian stock market is going through a similar era of easy money right now, though of a lower degree in comparison to the dot-com bubble that was on in the United States in the late 1990s. Hence, making predictions is going to about predicting investor psychology than the underlying fundamentals.
Given this, it won’t be surprising to see forecasts predicting that Nifty will cross 10,000 points next year, coming out over the next few years. Of course all these forecasts will indulge in what American writer Steven Pinker calls “compulsive hedging”. As he writes in his new book
The Sense of Style “Many writers cushion their prose with wads of fluff that imply that they are not willing to stand behind what they are saying.”
The UBS analysts do just that. After predicting that Nifty will touch 9600 points by end 2015. They go on to write “If our expectations of the earnings growth recovery are not met (with only 10-12%
growth in corporate earnings)…the Nifty could decline to the 7,500 levels.”
So much for being in the business of making predictions.

The article originally appeared on www.FirstBiz.com on Nov 15, 2014

(Vivek Kaul is the author of the Easy Money trilogy. He can be reached at [email protected])

Goldman Sachs' Nifty target of 7600 needs to be taken with a pinch of salt

 goldman sachsVivek Kaul  
The investment bank Goldman Sachs is at it again. In a report dated March 14, 2014, the bank said that it expects the Nifty index to touch 7600 points during 2014. As I write this (on March 19, 2014, around noon) the Nifty is at around 6526 points.
This means that the Nifty needs to rally by around 16.5% from its current level to touch 7600 points. And if the Sensex rallies by similar levels it will cross 25,000 points during the course of the year.
Goldman Sachs offered a spate of reasons justifying the target of 7600 points for the Nifty (
You can read them here). The only trouble here is that similar predictions made by Goldman Sachs in the past have gone majorly wrong.
Blogger and analyst Deepak Shenoy writes about these predictions in a post on his blog www.capitalmind.in. In November 2012, Goldman Sachs predicted that India will grow by 6.5% during 2013. The actual growth came in at less than 5%.
In March 2012, the investment bank predicted that by March 2013, 
Nifty would touch 6100 points. As on March 28, 2013, the Nifty was way lower at 5682.55 points. In August 2011, the investment bank predicted that by September 2012, the Nifty would touch 6600 points. As on September 28, 2012, the Nifty was at 5730.3 points. It only got anywhere near 6600 points very recently.
So that is how the past predictions of Goldman Sachs have gone. Hence, why take this new prediction seriously?
In fact, truth be told, Goldman Sachs is not the only financial firm making such predictions. They come by the dozen. Here are a few such predictions that were made at the beginning of this year. CLSA has predicted that the Sensex will touch 23,500 points by December 2014. Deutsche Bank Markets Research did better than CLSA and predicted that Sensex will touch 24,000 points by the end of this year. And Goldman Sachs in an earlier report dated November 5, 2013, had predicted that the Nifty would touch 6900 points by the end of 2014. This target has now been upped to 7600 points.
The economist John Kenneth Galbraith termed the entire business of prediction as a fraud. As he writes in
The Economics of Innocent Fraud “The fraud begins with a controlling fact, inescapably evident but universally ignored. It is that the future of economic performance of the economy, the passage from good times to recession or depression and back, cannot be foretold. There are more ample predictions but no firm knowledge.”
And why is that? “There is the variable effect of exports, imports, capital movements and corporate, public and government reaction thereto. Thus the all-too-evident-fact: The combined result of the unknown cannot be known,” writes Galbraith.
Given this, why are such predictions made? For one, making such predictions is a fairly lucrative career option. Also, investors (like most other people) want to know in which direction are the markets headed. In the recent past, there have been a spate of reports which essentially have been telling us that markets will continue to go up, because Narendra Modi will be the next prime minister of India.
The stock market investors are largely supporters of Modi, and any report that links Modi and the stock market going up is music to their ears. Sometime back an Indian stock brokerage predicted that Narendra Modi is likely to win the next elections and even made projections on how many seats the Bhartiya Janata Party is likely to win. This after some of its analysts had travelled six hundred kilometres through fifteen districts.
In a country where the most detailed polls go wrong, how can anyone in their right mind make a prediction on the number of seats a party is likely to win, after travelling through just 15 districts? The report was immediately lapped up by the pink papers and their readers, given that Narendra Modi winning the elections is music to their ears. As Galbraith puts it “The men and women so engaged believe and are believed by others to have knowledge of the unknown; research is thought to create such knowledge. Because what is predicted is what others wish to hear and what they wish to profit or have some return from, hope or need covers reality.”
Also, financial firms need a story to sell stocks to their clients. As the old saying goes, every bull market has a theory behind it. Andy Kessler, who used to be analyst with Morgan Stanley, recalls his experience in 
Wall Street Meat. As he writes “The market opens for trading five days a week… Companies report earnings once every quarter. But stocks trade about 250 days a year. Something has to make them move up or down the other 246 days [250 days – the four days on which companies declare quarterly results]. Analysts fill that role. They recommend stocks, change recommendations, change earnings estimates, pound the table—whatever it takes for a sales force to go out with a story so someone will trade with the firm and generate commissions.”
Predicting which way the stock market is headed is also a part of this game. Also, revising targets is an important part of this game. As Kessler writes “For some reason, Morgan Stanley was into price targets. I hated them. To me, they were pure marketing fluff. I would recommend Intel at, say $25. The first question I would get is what is my price target. My answer would be $40 for no particularly good reason. It was high enough to interest investors, but I was guaranteed to be wrong. If it hit $38, it was a great call, but I was wrong. If it went to $60, it was an even better call, but I was still wrong. What usually happened was that if the stock hit $35, I was asked to adjust my price target to $50, so that sales force would have a call to go out with.”
Let’s understand this in the context of Goldman Sachs’ Nifty target of 7600. In November 2013, the firm predicted that Nifty would touch 6900 by the end of 2014. Three months into the year the Nifty has already crossed 6500 points and hence, a target of 6900 points doesn’t sound ‘sexy’ enough. The solution, of course, is a new target which is at a much higher 7600 points.
What this also does is that it gives the financial firm a lot of coverage in the media. Every pink paper in the country, along with almost all business news websites have carried the news about Goldman Sachs’ new Nifty target. So, in a way it’s free advertising for Goldman Sachs.
Interestingly, when the stock market hit an all time high in January 2008, a stock brokerage which was looking to go public, released a report saying that the Sensex will touch 25,000 points before the end of the year. The report was covered comprehensively through the day across all business news channels. The next day the pink papers also splashed the news big time. So, the stock brokerage got the publicity that it needed. Of course, the Sensex still hasn’t touched 25,000 points, more than six years later.
This is not to say that the Sensex will not cross 25,000 by the end of the year or the Nifty will not touch 7600 points, as predicted by Goldman Sachs. For you all we know that might turn out to be the case. And the analysts at Goldman will then be termed as visionary. But when it comes to markets, it is always worth remembering what John Maynard Keynes, the great man that he was, once said: “Markets can remain irrational longer than you can remain solvent.”  

The article originally appeared on www.FirstBiz.com on March 19, 2014
(Vivek Kaul is a writer. He tweets @kaul_vivek) 

The only stock tip you will ever need: Watch the Dow

Vivek Kaul
The Dow Jones Industrial Average (DJIA), America’s premier stock market index, has been quoting at all-time-high levels. On 7 March 2013, it closed at 14,329.49 points. This has happened in an environment where the American economy and corporate profitability has been down in the dumps.
The Indian stock markets too are less than 10 percent away from their all-time peaks even though the economy will barely grow at 5 percent this year.
All the easy money created by the Federal Reserve is landing up in the stock market. So the stock market is going up because there is too much money chasing stocks. ReutersIn this scenario, should one  dump stocks or buy them?
The short answer is simple: as long as the other markets are doing fine, we will do fine too. The Indian market’s performance is more closely linked to the fortunes of other stock markets than to Indian economic performance.
So watch the world and then invest in the Sensex or Nifty. You can’t normally go wrong on this.
Let’s see how the connection between the real economy and the stock market has broken down after the Lehman crisis.
The accompanying chart below proves a part of the point I am trying to make. It tells us that the total liabilities of the American government are huge and currently stand at 541 percent of GDP. The American GDP is around $15 trillion. Hence the total liability of the American government comes to around $81 trillion (541 percent of $15 trillion).
Source: Global Strategy Weekly, Cross Asset Research, Societe Generate, March 7, 2013
Source: Global Strategy Weekly, Cross Asset Research, Societe Generate, March 7, 2013
The total liability of any government includes not only the debt that it currently owes to others but also amounts that it will have to pay out in the days to come and is currently not budgeting for.
Allow me to explain.  As economist Laurence Kotlikoff wrote in a column in July last year, “The 78 million-strong baby boom generation is starting to retire in droves. On average, each retiring boomer can expect to receive roughly $35,000, adjusted for inflation, in Social Security, Medicare, and Medicaid benefits. Multiply $35,000 by 78 million pairs of outstretched hands and you get close to $3 trillion per year in costs.”
The $3trillion per year that the American government needs to pay its citizens in the years to come will not come out of thin air. In order to pay out that money, the government needs to start investing that money now. And that is not happening. Hence, this potential liability in the years to come is said to be unfunded. But it’s a liability nonetheless. It is an amount that the American government will owe to its citizens. Hence, it needs to be included while calculating the overall liability of the American government.
So the total liabilities of the American government come to around $81 trillion. The annual world GDP is around $60 trillion. This should give you, dear reader, some sense of the enormity of the number that we are talking about.
And that’s just one part of the American economic story. In the three months ending December 2012, the American GDP shrank by 0.1 percent. The “U3” measure of unemployment in January 2013 stood at 7.9 percent of the labour force. There are various ways in which the Bureau of Labour Standards in the United States measures unemployment. This ranges from U1 to U6. The official rate of unemployment is the U3, which is the proportion of the civilian labour force that is unemployed but actively seeking employment.
U6 is the broadest definition of unemployment and includes workers who want to work full-time but are working part-time because there are no full-time jobs available. It also includes “discouraged workers”, or people who have stopped looking for work because economic conditions make them believe that no work is available for them. This number for January, 2013, stood at 14.4  percent.
The business conditions are also deteriorating. As Michael Lombardi of Profit Confidential recently wrote, “As for business conditions, they appear bright only if you look at the stock market. In reality, they are deteriorating in the US economy. For the first quarter of 2013, the expectations of corporate earnings of companies in the S&P 500 have turned negative. Corporate earnings were negative in the third quarter of 2012, too.”
The average American consumer is not doing well either. “Consumer spending, hands down the biggest contributor of economic growth in the US economy, looks to be tumbling. In January, the disposable income of households in the US economy, after taking into consideration inflation and taxes, dropped four percent—the biggest single-month drop in 20 years!,” writes Lombardi.
Consumption makes up for nearly 70 percent of the American GDP. And when the American consumer is in the mess that he is where is the question of economic growth returning?
So why is the stock market rallying then? A stock market ultimately needs to reflect the prevailing business and economic conditions, which is clearly not the case currently.
The answer lies in all the money that is being printed by the Federal Reserve of the United States, the American central bank. Currently, the Federal Reserve prints $85 billion every month, in a bid to keep long-term interest rates on hold and get the American consumer to borrow again. The size of its balance-sheet has touched nearly $3 trillion. It was at around $800 billion at the start of the financial crisis in September 2008.
As Lombardi puts it, “When trillions of dollars in paper money are created out of thin air and interest rates are simultaneously reduced to zero, where else would investors put their money?”
All the easy money created by the Federal Reserve is landing up in the stock market.
So the stock market is going up because there is too much money chasing stocks. The broader point is that the stock markets have little to do with the overall state of economy and business.
This is something that Aswath Damodaran, valuation guru, and professor at the Columbia University in New York, seemed to agree with, when I asked him in a recent interview about how strong is the link between economic growth and stock markets? “It is getting weaker and weaker every year,” he had replied.
This holds even in the context of the stock market in India. The economy which was growing at more than 8 percent per year is now barely growing at 5 percent per year. Inflation is high at 10 percent. Borrowing rates are higher than that. When it comes to fiscal deficit we are placed 148 out of the 150 emerging markets in the world. This means only two countries have a higher fiscal deficit as a percentage of their GDP, in comparison to India. Our inflation rank is around 118-119 out of the 150 emerging markets.
More and more Indian corporates are investing abroad rather than in India (Source: This discussion featuring Morgan Stanley’s Ruchir Sharma and the Chief Economic Advisor to the government Raghuram Rajan on NDTV)But despite all these negatives, the BSE Sensex, India’s premier stock market index, is only a few percentage points away from its all-time high level.
Sharma, Managing Director and head of the Emerging Markets Equity team at Morgan Stanley Investment Management, had a very interesting point to make. He used thefollowing slide to show how closely the Indian stock market was related to the other emerging markets of the world.
India’s premier stock market index, is only a few percentage points away from its all-time high level.
As he put it, “It has a correlation of more than 0.9. It is the most highly correlated stock market in the entire world with the emerging market averages.”
So we might like to think that we are different but we are not. “We love to make local noises about how will the market react pre-budget/post-budget and so on, but the big picture is this. What drives a stock market in the short term, medium term and long term is how the other stock markets are doing,” said Sharma. So if the other stock markets are going up, so does the stock market in India and vice versa.
In fact, one can even broaden the argument here. The state of the American stock market also has a huge impact on how the other stock markets around the world perform. So as long as the Federal Reserve keeps printing money, the Dow will keep doing well. And this in turn will have a positive impact on other markets around the world.
To conclude let me quote Lombardi of Profit Confidential again “I believe the longer the Federal Reserve continues with its quantitative easing and easy monetary policy, the bigger the eventual problem is going to be. Consider this: what happens to the Dow Jones Industrial Average when the Fed stops printing paper money, stops purchasing US bonds, and starts to raise interest rates? The opposite of a rising stock market is what happens.”
But the moral is this: when the world booms, India too booms. Keep your fingers crossed if the boom is lowered some time in the future.
The article originally appeared on www.firstpost.com on March 8, 2013.
Vivek Kaul is a writer. He tweets @kaul_vivek