Does a rally in share prices reflect better health of the economy or is it the pink economic health that causes share prices to rise? By G Raghavan, professor of finance, SDM Institute for Management Development and R Nivedita, senior MBA student.

"It is usually agreed that casinos should, in the public interest, be inaccessible and expensive. And perhaps the same is true of Stock Exchanges" wrote John Maynard Keynes in 1935. Despite this dig, Keynes also recognised that stock markets enable people with money to invest together with people who can put that investment to productive use.

Globally, capital markets generally exhibit, particularly in the developed and emerging markets, the traits of a 'more or less' perfect market with no or 'acceptable' entry barriers, large number of buyers and sellers, absence of, or very low, transaction costs, tax parity, and free trading.

And this is only fascinating and facilitating international investors to invest huge sums of money in international markets. To attract such international investments, countries compete with each other and promote their capital markets with savvy sops and policy announcements. It is in fact a reality that no modern economy can exist without an efficient capital market.

Having said that, the debate surrounding the relationship between capital market performance (mainly through share prices or index movements) and macroeconomic growth is still a hotly debated topic among economists, policy makers, and finance professionals.

In the current environment, where increasing integration of the financial markets with capital market reform measures is taking place, the activities in the stock markets and their relationships with the macro economy have assumed significant importance.

Any news about the inflation rate, the rate of economic growth, employment, consumer spending, and other economic variables has significant impact on share prices in general. A given piece of economic news also impacts different sectors within the overall market.

This short note is an attempt to examine the relationship between share prices and the status of the economy by looking at their performance in India - the modern enlightened investors' ultimate destination?

What is the relationship between the health of the real economy and the health of the stock market? Does a rally in share prices reflect better health of the economy or is it the pink economic health that causes share prices to rise?

A causal relationship between the share price index and industrial production can be easily established. However, it may require time and effort to study and establish interdisciplinary relationships with crucial macroeconomic variables like money supply, credit to the private sector, exchange rate, wholesale price index, and money market rate.

Between 1995 and 2004, the real GDP in India experienced positive growth every year, ranging from a low of 4.0 per cent to 8.5 per cent. The Bombay Sensex, on the other hand, has experienced great volatility during this period, ranging from a negative 27.9 per cent to a positive 83.4 per cent.

If one were to look at the real GDP growth and BSE Sensex over the entire time horizon, 1995 and 2004, one can clearly see their co-relation. The real GDP growth was 6.1per cent and the Sensex posted a 6.2 per cent growth, both using CAGR (compounded annual growth rate reckoned).

However, a closer and deeper year-on-year examination reveals a different picture. We find that while the real GDP growth has been at a steady rate on an annual basis during this period, the BSE Sensex has had a very volatile trend. On a year-on-year basis, there seems to be no sync at all between these two factors.

However, the growth in nominal GDP matches that of the corporate performance year after year and hence there is a fair degree of co-relation. This may be due to the fact that the GDP of the economy is the collective output of the agriculture, industrial, and services sectors.

It can, therefore, be asserted that corporate performance tends to trace GDP growth over the long-term (very important assumption), and it is assumed that the stock market follows suit. In the long-run, the economy goes through cycles of recovery, peak, slowdown, and depression. Stock markets also exhibit similar cycles. Hence, if India's GDP grows at 10 per cent in one year, the Sensex may not gain a similar percentage during that year. However, the relationship may hold true over the longer-term. It may be stated that the state of the economy has a bearing on the share prices but the health of the stock market in the sense of a rising share price index is not reflective of an improvement in the health of the economy.

In the U.S. economy too there has been an identifiable link in the last century (of course, a weak one) between the state of the economy and stock market performance.

The purpose of this study was to establish the relationship between economic growth and the stock market especially in terms of stock prices. This finding has lots of implications for the kind of rallies we are witnessing in the Indian stock market in the recent months - Sensex crossing the 11000 mark without losing steam to clear the 12000 mark further.

To conclude, while it is established that fundamentals dictate stock market directions over the longer-term, there are pitfalls in such assumptions in the short-run, which one has to acknowledge. This is perhaps one of the key reasons why investors could adopt a long-term strategy while investing in stocks.

(Courtesy 'Capco Institute', the research arm of Capco
www.capco.com/capcoinstitute).