Is the stock market a ‘barometer' of the economy?

Is the stock market a ‘barometer' of the economy? Any suggestion to that effect is usually met with howls of protest in India. Some question how the stock market can represent the economy when a good portion of the output originates from activities like agriculture which have nothing to do with listed companies.

Then there is the fact that stock prices gyrate wildly from day to day, when corporate or economic fundamentals certainly don't. This leads cynics to argue that stock prices are purely a function of liquidity and have nothing to do with esoteric notions of ‘fundamentals' or ‘intrinsic worth'.

Nevertheless, a section of economists have over the years made a brave attempt to explain the relationship between stock valuations and the corporate assets they represent. The market capitalisation to GDP ratio, Tobin's q (market value to replacement cost of assets) and price-earnings multiple are usually cited by financial analysts to explain prices. However, they still offer only a partial explanation to the puzzle of stock valuations.

Fresh framework

A recent paper, Indian Equity Markets: Measures of Fundamental Value ( http://www.nber.org/papers/w16061), by Rajnish Mehra, Department of Economics, University of California, offers a fresh and more comprehensive framework to examine if Indian equity valuations are in line with corporate fundamentals. It comes up with the somewhat surprising conclusion that they are!

Using a quantitative model to predict what ‘fundamental values' in the Indian market should be, it finds that actual stock values were broadly in line with them between 1991 and 2008.

The paper builds on the theoretical premise that if markets were fairly valued, the price that investors are willing to pay for firms (market value of their equity plus debt) should be equal to the replacement cost of the assets that firms employ. Both values are pegged to the country's GDP (excluding its agriculture component) to normalise them.

Three aspects are factored into the evaluation of fundamentals: corporate capital stock (assets), after-tax corporate cash flows and net corporate debt. An interesting aspect of the study is its attempt to quantify ‘intangible assets' (brands, research and development, technical know-how and the all-important human capital), drawing on earlier research in the American context (McGrattan and Prescott & Corrado et al). It finds that Indian firms have sharply enhanced their ‘intangible' capital in recent years, aiding stock valuations.

Watershed year

All the above research leads to the comforting conclusion that “in a large measure, Indian equity markets were fairly priced between 1991 and 2008.”

It throws up other observations too that offer food for thought to investors. The paper notes that though corporate values have largely moved in sync with ‘fundamentals' between 1991 and 2008, the markets have become more expensive in recent years. It turns out that 2005 was a watershed year for India's stock market.

Through 1991-2004, stock values hovered in a narrow band around the adjusted GDP. Actual stock values in this period also hovered much below the ‘fundamental values', showing an undervalued market. However, the years from 2005 to 2008 saw stock prices suddenly shift gears, with valuations shooting up relative to adjusted GDP. The proportion of corporate values to adjusted GDP moved up to 1.468 in 2005-08, from 0.78 in 1991-2004.

However, this is not a cause for alarm, as higher stock values were supported by a step-up in private investment and the higher ‘intangibles' employed by companies. Nor did market values move wholly out of range of the ‘fundamental' values modelled. The paper goes on to estimate the current ‘fundamental value' at about 1.2 times and says that it may eventually stabilise at around 1.5 times. A hint that stock markets may have room for upside, if the economy continues to grow?

Qualifiers

The qualifiers to this paper are fairly important, though. The author cautions that “although our framework is well suited to examining secular movements in the value of equity relative to GDP, it is not suitable to address high frequency price movements in the stock market”, adding for good measure that “high frequency volatility remains a puzzle”. The other key effect that the paper has not accounted for is the demand for stocks from foreign institutional investors (FIIs).

However, actual stock price behaviour suggests that these two aspects could well be interrelated. As of today, more of the ‘demand' for Indian shares originates from FIIs, rather than domestic investors (only 6 per cent or so of Indian household savings go into equities). Therefore, whether we like it or not, irrespective of how robust or otherwise India's fundamentals are, it is liquidity from FIIs that decides stock values.

The money that FIIs allocate to the Indian market tends to ebb and flow on a daily basis, depending on global events and the attractiveness of other options in the FII basket. And there may lie the explanation for the unprovoked swings in India's stock market valuations and also its highly volatile stock prices.