Why the economy may not be linked to the stock market

A rising stock market measured by an index such as S&P500, Nifty, Sensex shows a booming economy and positive sentiment. On the other hand, a falling stock market shows the opposite.
However, over the last decade, the stock market and the economy have started to show divergence. Today it can be said there is not much correlation between the two. Why?

The make-up of the economy and the stock market is different today

Indexes such as Nifty and Sensex are dominated by sectors such as financial services, telecom, and IT, which may not represent the Indian economy. Similarly, in the US - the index is dominated by Tech (FAANG stocks), which form a small part of the overall economy but a large part of the stock market. Most of India’s employment tends to be in SMEs, manufacturing, trading, agriculture, which has a minuscule representation in the stock market.

The stock market is linked to profitability, 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. In conclusion - the stock market reacts on profitability, not growth.

Market tend to be forward-looking

We saw in the 2008 crisis that the stock markets recovered in 2009, but the economy recovered in 2011/12. We saw the same phenomena last year in 2020. Stocks 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.

Companies are increasingly global in nature

Most large companies in India and the US have global business models. They are less tied to the domestic economy today than they were 10-15 years ago. 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. So traditional metrics comparing market and GDP may not be relevant today as businesses become global. Specific large sectors such as IT India are primarily international.

Stock markets reflect large companies mostly

The way indexes such as Sensex and Nifty work is that the larger the company, the more significant the impact on the index. Today in India and the US - 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 different. The same goes for the US - where the top 10/20 are responsible for most of the index today. So today, the stock markets are more of a reflection of the top 20 companies in India than it is of the economy.

What about the Covid crisis?

The Covid crisis in 2020 was devastating in terms of economic damage and the livelihoods of millions in India. Despite this - it was good for financial services, IT and telecom as most people started spending most of their time at home. Sectors that had a terrible impact, such as real estate, transportation, auto, hotels, had little effect on the market due to the lack of large companies in the space.

Even in the US - working from home led to a massive boom in technology stocks and hence the same impact. In conclusion - there is an increasing divergence between the stock market and the economy. The state of the economy has much less of an impact today than 10-20 years ago, and investors should keep in mind when making decisions regarding investing.