Home Relationship Between Stock Prices and the Real Economy

Relationship Between Stock Prices and the Real Economy

Over the last 10-15 years, Indian stock markets have seen about 3-4 crashes and an equal number of booms. If one were to analyze the boom and bust cycles of the stock market, it would appear that the economy really did not suffer as badly as the stocks, nor did it outperform the markets. What then is the relation between the stock prices and the real economy?

It is believed that the stock “markets are always ahead” of the real economy and can indicate beforehand the state of the economy i.e. they decline before the economy as a whole declines and improve before the general economy begins to recover. The reason for this belief may well be the fact that the sharpest minds (for good or bad) work in the financial markets as opposed to the real economy. They are constantly predicting the future of the stock markets and are able to spot its movement before the real economy latches on. The other theory which supports stock market’s predictive ability is the “wealth effect” which argues that fluctuations in stock prices have a direct effect on aggregate spending. When the stock market is rising, investors are wealthier and may spend more. As a result, economy expands. On the other hand, if stock prices are declining, investors are less wealthy and spend less. This results in slower economic growth. On that logic, the real economy always trails the stock market. Sounds logical, but any empirical evidence to prove this point? So does the stock market always look ahead, anticipating future events?

On 19th March, 2013, the Dow Jones surged to its highest closing level ever. The Dow closed at 14,254, passing its previous high of 14,164.52 made in October 2007. Where is the so called real economy in the United States? Far from recovery I would say. Declining corporate profits, federal spending cuts and a state of high unemployment are all driving down consumption in the U.S. If you believe in the “markets are always ahead” theory, then could this be an early signal from equities that the U.S. economy is coming out of a recession? 

Analysts closely follow the many economic indicators which influence (or are supposed to influence) how stock markets perform and as empirical evidence suggests, these indicators certainly have an impact on equity prices. Whether this impact is justified or not is also influenced. In reality, forecasting stock price movements is often done on the basis of economic indicators which are themselves being forecasted ahead of time. 

To explain by an example as to how these indicators have an impact – let’s say RBI increases interest rates because of rising inflation. This increases the borrowing cost of companies which will add to their cost of production and bring down their profits. This will naturally have a negative effect on the share prices of those companies. So RBI’s action of increasing the interest rates creates a negative sentiment which leads to selling.

We tried to compare a key economic indicator – the GDP figure with the stock prices for the last 7 years, to include the period preceding the 2008 crash and then what followed since then up until now.

Key Economic Indicators

One very evident trend which is hard to miss is the current gap between the GDP and the stock prices. Does it indicate that our economy should start improving? Given that this gap has been ever increasing (at least in the last 5-6 quarters) it’s hard to believe this. On the contrary, while there is dissatisfaction amongst the investors about the poor performance of the equity markets, this chart would show the exact opposite i.e. the markets are overvalued and in a state of unnecessary exuberance. There is hardly a sign of improvement in the economy. In fact if you look at the historical data, it seems that our markets are so far ahead of the real economy that one should not be surprised if there is a big correction from this point. And this is based purely on the GDP. Add to it, high inflation, political uncertainty and low consumption, you will find little reason to explain this gap.

Indeed, if you believe that “markets are always ahead” of the real economy then could this be an early signal from equities that the economy is coming out of a recession?