The recently published GDP numbers for Q4FY11 are indeed a pointer towards a slowing down of the Indian economy. Between January–March 2011, the Indian economy grew by 7.8%, the slowest in the last five quarters and clearly 1.7% lower than what was achieved during the same quarter in the preceding year. How much does a lower GDP growth impact the performance of the stock markets? Does the slowing down of the economy necessarily mean a period of lower stock returns? In the current economic and market scenario it is important to address this question.
A general belief is that higher economic growth automatically translates into better stock market returns. Even fund managers pitch this as an essential concept particularly when they are out raising money to invest in emerging markets. The basic tenet on which this theory rests is that the GDP of any nation is the aggregate of consumption, investment, government spending and net exports. Any acceleration in the consumption, investment or exports is definitely bound to have a positive impact on corporate sales. Better corporate sales mean a higher EPS (earning per share) and a higher EPS will in turn translate into higher market returns. This is as true in the opposite direction too.
While theories abound in every field and more so in the financial space, the practical applicability of many theories is always a matter of doubt unless proved conclusively. So, how much of the above is practically true? Let’s first look at how the GDP growth rate affects corporate earnings. If you look at the data since the beginning of 1992, corporate earnings follow GDP growth in the long run. Since FY92 the aggregate EPS of Sensex-based companies grew at a CAGR of 12%, whereas the GDP (in real terms) of the country grew by 6.6% during the same period. The reason for this difference in growth rates of these two factors is that the GDP numbers are inflation-adjusted while the EPS is not.
However, in a year-on-year comparison they do not lock-step each other. Over the past 20 years we find that though the GDP continued to grow every year, there are four occasions when the EPS witnessed negative growth. Is there a perfect correlation between GDP growth and corporate net earnings? There is a very feeble (0.08) yet positive correlation between these two factors. As we all know, a perfect correlation is one where the GDP and the corporate earnings grow at the same rate. From the above discussion it is clear that the EPS of companies rises in general with a rise in the GDP but not necessarily in the same proportion.
Now let us analyse if growth in GDP translates into higher returns for investors. To check this we again analysed the same set of data for the last 20 years. We find that there is a negative correlation of 0.28 between the stock market returns and GDP growth. This might come as a surprise but when we check the experience of the other countries, including the developed nations, the result is no different. According to a study done by Morgan Stanley, the stock returns versus GDP growth for eight developed markets between 1958 and 2008 also show a negative correlation between the two factors. So what explains this negative correlation? Why do stock market returns not follow a linear path along with the GDP growth?
There are various reasons why we do not see a direct impact of growth in the GDP on stock market returns. Both are as different as cheese and chalk. First, the stock market acts as a lead indicator of the activity in any economy. Therefore it remains ahead of the economy. To check the validity of this, we analysed the correlation
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