Economic Fundamentals And The Stock Market

Economic Fundamentals and the Stock Market

Security Analysis Term Paper

Submitted to, Prof. T. D. Choudhury

Submitted by: Shradha Diwan 08 BS 000 3170 ICFAI Business School, Kolkata

[email protected]

INTRODUCTION SENSEX reached a peak of 20,000 and then fell like a pack of cards to 10,000. Do these numbers suggest anything about the macroeconomic growth of the country? “The stock market is a casino” – states the Keynesian thesis. However, it is also agonized that stock markets enable people with money to invest to come together with people who can put that money into productive use. The relationship between stock markets and macroeconomic growth has been the subject of numerous debates. Economists, analysts, and financial policymakers have conducted a plethora of studies on the subject but nothing substantial has been concluded as yet. Most market participants talk of economic fundamentals and say that as long as the years of unsatisfied demand in the country are still there, the growth story will continue. However, it is also a known fact that stock markets do not react to certain news at all, while reacting wildly even to some rumors. Surely, all those second-by-second movements cannot be based on economic fundamentals. Indeed, the exponential rise of the SENSEX also corresponds to one of the most spectacular periods of growth in the economy (when the country witnessed a CAGR of 8.6% for three consecutive years). Most sectors, except agriculture, have witnessed above average growth. Some analysts became concerned about a price bubble being created in the stock markets. A financial bubble arises when the market prices are not reflective of the actual reality. Exuberance in the stock market which is not based on economic fundamentals, but on support from speculators, is likely to be irrational.

The assignment deals with analyzing the impact of economic fundamentals on the Stock markets. For the objective, the macroeconomic factors considered are: 1. Impact of GDP of the country on the stock markets 2. Impact of Foreign Institutional Investors (FIIs) on the Indian Financial Markets, including the Stock market, and how this hot money turned out to be the country’s biggest foe in times of financial crisis

[email protected]

CORRELATION BETWEEN GDP AND SENSEX The following statistical analyses deal with establishing a relationship between India’s GDP and the BSE SENSEX and observing if there exist substantial correlation between the two over a period of 10 years. Methodology: 1. The statistical correlation between the SENSEX and the GDP (constant prices, base 1999-00) of India is calculated 2. The period of the study is from the first quarter of FY 1999-00 to the last quarter of FY 2008-09 (10 years) 3. In order to make the SENSEX comparable with quarterly GDP, quarterly averages of the SENSEX are taken 4. The annual correlations between GDP and SENSEX are also calculated 5. The 4 quarters’ moving averages of the SENSEX and GDP are calculated 6. The regression model between SENSEX and GDP is also obtained (Dependent variable – Sensex; Independent Variable - GDP)

The following are the observations: Step 1: Statistical correlation between the SENSEX and the GDP (constant prices, base 1999-00) of India Period of the Study: Q1 FY 1999-00 to Q4 FY 2008-09 The correlation is 0.840 This is our first linkage. (Refer Annexure A for data)

Correlations GDP GDP

BSE

Pearson Correlation Sig. (2-tailed) N Pearson Correlation Sig. (2-tailed) N

1 . 40 .840** .000 40

BSE .840** .000 40 1 . 40

**. Correlation is signif icant at the 0.01 level (2-tailed).

[email protected]

Step 2: 4 quarters’ moving average of SENSEX and GDP Step3: Annual correlations of GDP and SENSEX From the following graphs, it can be observed that GDP and SENSEX show a high degree of correlation between the period 2002-03 and 2006-07. However, if we analyze the data more deeply, year-on-year examination gives a different picture. The outcome of this examination shows that though the real GDP as shown a steady growth over the period of study, BSE SENSEX has been very volatile during the entire period. On year-on-year basis, there seems to be no sync between the two factors. (Refer Annexure B for data)

[email protected]

Regression Model: It is observed that the R-square value of the model is .706 with acceptable t-values. The model establishes the role of fundamentals in terms of quarterly GDP of the country and the stock market. From the model, we see that the beta of the regression model is 0.840. such a high positive value of beta indicates strong positive sensitivity between the SENSEX and the GDP.

Model Sum m ary

Model 1

R .840a

R Square .706

Adjusted R Square .698

Std. Error of the Estimate 2583.14988

a. Predictors: (Constant), GDP

ANOVAb

Model 1

Regression Residual Total

Sum of Squares 6.09E+08 2.54E+08 8.62E+08

df 1 38 39

Mean Square 608810540.1 6672663.286

F 91.240

Sig. .000a

a. Predictors: (Constant), GDP b. Dependent Variable: BSE

Coe fficientsa

Model 1

(Constant) GDP

Unstandardized Coef ficients B Std. Error -9689.309 1849.908 2.847E-02 .003

Standardized Coef ficients Beta .840

t -5.238 9.552

Sig. .000 .000

a. Dependent Variable: BSE

[email protected]

The Financial Crisis and India’s Financial Markets: Despite the vanishing foreign institutional investors (FIIs), the Indian markets remained resilient and stayed afloat. Investors’ sentiments have been significantly impacted by the US financial crisis. The tendency of investors to withdraw from risky markets has resulted in significant capital outflows that have led to a liquidity crunch putting pressure on the Indian stock market. The Indian economy continues to show good health because of the strength of its domestic drivers, like infrastructure projects, SME (small and medium enterprises) sector exports and good yielding from the agricultural sector. The cause behind US economy debacle is that the US investment banks are extremely over leveraged and solely dependent on whole sale finances. This led to their demise. But such is not the case with Indian Banks. The common man’s deposits are more in India and they have the trust on the Banks, because all most all the Banks are nationalized and the depositor’s interest is highly protected by Government of India.

Decline in RBI’s Forex Reserves Depreciation of the Rupee Decline in Stock Market Indices

In the US, the investment banks are dependent on institutional investor’s funds. These investments are highly volatile and always search for high returns on their deposits. They look for Demand-based investments and not time-based investments. Therefore, whenever the returns from one market start dipping, they move their investment to re-invest in those markets which would offer a better return, or take a defensive stance until the market regains momentum. Domestic banking in India is generally secure, especially because nationalized banking remains at the core of the system. Even so, there exist signs of fragility and inadequacy within the banking sector. The effects of the global crisis have directly impacted some important macroeconomic variables. Three such indicators stand out in terms of their sudden deterioration since the middle of last year: (i) (ii) (iii)

Decline in the foreign exchange reserves held by the Reserve Bank of India Fall in the external value of the rupee, especially vis-à-vis the US dollar Decline in the stock market indices

Measures taken by the RBI to stop depreciation of the Rupee led to a steep decline in its foreign exchange reserves. Factors which also contributed to the decline were the revaluation in foreign currencies and large scale pullout by foreign institutional investors. [email protected]

Figure 1: Foreign Exchange Reserves held by the RBI. Source: The Hindu BusinessLine

Figure 1 shows how the foreign exchange reserves, which had been increasing steadily over the past few years, started declining after June 2008. Not that the earlier build-up of reserves reflected any great macroeconomic strength, since unlike China it was not based on current account surpluses. Instead, the Indian economy experienced an inflow of hot money, especially in the form of

portfolio capital investment of FII. But that movement of FIIs was in turn related to the sudden collapse of the rupee, shown in Figure 2. Early in March 2009 the rupee even breached the line of Rs 51 per dollar. There are those who argue that this depreciation is positive since it will help exports, but conditions prevailing in the world trade market, with falling export volumes and values, does not give rise to much optimism in that context.

Figure 2: Rupees

per US Dollar; Source: The Hindu BusinessLine

India currently has a current account deficit, including a large trade deficit and also quite significant factor payments abroad. The falling rupee implies rising factor payments (such as debt repayment and profit repatriation) in rupee terms, which is not good news for many companies for the balance of payments. Associated with all this is the evidence of falling business confidence expressed in the stock market indicators. The Sensex (Figure 3) had reached historically high levels in the early part of 2008, capping an almost hysterical rise over the previous [email protected] Figure 3: Sensex Daily Movements; Source: The Hindu BusinessLine

three years in which it more than tripled in value. But it has been plummeting since then, with high volatility around an overall declining trend such that its levels in early March were below the levels attained in December 2005. Role of Foreign Investors:

Figure 4 tracks the changes in total foreign investment, split up into direct investment and portfolio investment, over a period since April 2007. It is evident that both have shown a trend of increase followed by decline. FDI has been more stable with relatively moderate fluctuations (even though it does include some portfolio-type investments that get categorized Figure 4: Foreign Investment; Source: The Hindu BusinessLine as FDI). It peaked in February 2008 and thereafter it has been coming down but is still positive. Portfolio investment has been extremely volatile and largely negative (indicating net outflows) since the beginning of 2008, and this has dominated the overall foreign investment trend. As a result, as is evident from Figure 5, the cumulative value of stock of Indian equity held by FIIs fell quite sharply, by 24% between May 2008 and February 2009. This is not likely to be due to any dramatically changed investor perceptions of the Indian economy, since if anything GDP Figure 5: Cumulative FII Investments in Equity; Source: The Hindu BusinessLine growth prospects in India remain somewhat higher than in most other developed or emerging markets. Rather, it is because portfolio investors have been repatriating capital back to the US and other Northern markets. This reflects not so much as a flight to safety (for clearly US securities are not safe anymore either) as the need to cover losses that have been incurred in sub-prime mortgages and

[email protected]

other asset markets in the North, and to ensure liquidity for transactions as the credit crunch began to bite. Whatever the causes, the impact on the domestic stock market has been sharp and direct. Since the Indian stock market is still relatively shallow, and FII activities play a disproportionately sharp role in determining the movement of the indices, it is not surprising that this flow has been associated with the overall decline in stock market valuations.

As Figure 6 shows, the Sensex has moved generally in the same direction as net FII inflows. In fact, movements in the latter have been much sharper and more volatile, suggesting that domestic investors have played a more stabilizing role over this period.

Figure 6: FIIs and the Stock Market; Source: The Hindu BusinessLine

Overall foreign investment flows (including both FII and direct investment) have also played a role in determining the level of external reserves. Figure 7 shows the pattern in aggregate net foreign investment and change in reserves since April 2007. Once again, the two move together. However, in this case, foreign investment has been less volatile than the change in reserves, suggesting that other components of the balance of payments have

Figure 7: Foreign Investment and Change in Reserves; Source: The Hindu BusinessLine

[email protected]

been important as well. The changes in external commercial borrowing are likely to be significant. In addition, the possibilities of domestic investors moving their funds out should not be underestimated. The recently liberalized rules for capital outflow by domestic residents have led to outflows that are not insignificant, even if still relatively small.

[email protected]

CONCLUSION If we look at the trend, stock markets are not always guided by fundamentals but also by sentiments. For instance, lowering of interest rates by the RBI typically has an impact on the economy with a lag. But the signal that the RBI is reducing interest rates may prop up stock markets immediately and stock prices may react much faster. However, in the present period there is a change in the trend, due to the fact that Indian economy is now more integrated with global world than before. At worldwide level capital markets evince attributes of 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. To attract international investments, countries compete with each other and promote their capital markets with savvy sops and policy announcements. No modern economy can exist without an efficient capital market. This is what has attracted international investors, who in recent years have made India their favorite destination. Since our markets are now globally integrated, if we look at recent trends, for instance, when IIP numbers were positive, still we were unable to lift the markets. However, most of the times we get to hear that markets are crashing due to weak global cues, or an uncertain event at international level has had an effect on our markets. The crux of the issue is that an economy goes through business cycles of recovery, boom, slowdown and recession. Stock market also moves on similar pattern. For instance if Indian GDP grows at 10 percent in one year, the SENSEX may not gain similar percentage during the same 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. Summing up the basic purpose of all studies done is to find out relations between economic growth and stock markets. Though it can’t be neglected that stock market directions are based on fundamentals in the long-term, however, these assumptions may turn out to be dangerous for investors in short-term. Therefore, most analysts would advice us to go for investment in stocks with a long-term perspective in mind

[email protected]

REFERENCES 1. Global Crisis and Indian Finance, C.P.Chandrasekhar and Jayati Ghosh, The Hindu BusinessLine 2. Global Crisis News, www.globalcrisisnews.com 3. www.rbi.org – Statistics on Indian Economy – Annual Publications 4. BSE India Website – Historical Prices of SENSEX 5. The Reserve Bank of India – Press Releases, Handbook of Statistics; Special Reports 6. Ministry of Communications and Information Technology – Statistics

[email protected]

Annexure A Year

GDP (Rs crore)

GDP 4 QUARTERS' MOVING AVERAGE

BSE SENSEX 4 MONTH AVERAGE

BSE SENSEX 4 QUARTERS' MOVING AVERAGE

99-00 Q1 Q2 Q3 Q4 00-01 Q1 Q2 Q3 Q4 01-02 Q1 Q2 Q3 Q4 02-03 Q1 Q2 Q3 Q4 03-04 Q1 Q2 Q3 Q4 04-05 Q1 Q2 Q3 Q4 05-06 Q1 Q2 Q3 Q4 06-07 Q1 Q2 Q3 Q4 07-08 Q1 Q2 Q3

421795

446631 452011.5 458612.25 463895.5 466075 471139.25 476705.25 485129.75 493151.75 499033.75 505007 507211.75 512072.75 518644.75 529220.75 544526.5 555689.75 566345.25 575470.25 583744 597096.5 609527.75 621468 636710.75 653211.75 667688.75 682674.25 698829 716077.25 731403.25 746721 763552.5 780715.5 795241.25 809417

0 4734.99 4690.863333 5218.013333 4613.31 4282.516667 3893.71 4059.38 3535.95 3128.61 3179.746667 3447.563333 3236.196667 3053.413333 3185.14 3194.253333 3249.223333 4163.526667 5263.55 5651.26 5070.056667 5315.336667 6169.75 6587.54 6687.8 8025.11 8693.02 10523.36333 10953.26333 11632.45 13481.70667 13367.03667 14355.78 16053.56333 19829.39

4613.674167 4814.294167 4701.175833 4501.8875 4212.229167 3942.889167 3654.4125 3475.921667 3322.9675 3248.029167 3229.23 3230.578333 3167.250833 3170.5075 3448.035833 3967.638333 4581.89 5037.098333 5325.050833 5551.600833 5785.670833 6190.106667 6867.55 7498.3675 8482.323333 9548.689167 10450.52417 11647.69583 12358.61417 13209.24333 14314.52167 15901.4425 16799.00583 17140.43417 16608.76917

396646 477775 490308 443317 423049 498908 499026 463574 445313 532606 531114 487102 469206 541425 550558 513390 511510 602648 595211 556012 548010 635743 648621 605737 595771 696714 714625 663645 655713 761333 783618 724949 716984 828659

[email protected]

Q4 08-09 Q1 Q2 Q3 Q4

852270

783052 773687 873426 902924

820608.75 833272.25 850012.3333 888175 902924

16957.29 15721.49333 13926.90333 9509.363333 9341.45

14028.7625 12124.8025 10925.90556 9425.406667 9341.45

[email protected]

ANNEXURE B Year

Correlation between GDP and Sensex

Sig (two tailed)

99-00 00-01 2001-02 2002-03 2003-04 2004-05 2005-06 2006-07 2007-08 2008-09

0.543 -0.762 0.077 0.497 0.912 0.969 0.84 0.948 0.71 -0.945

0.457 0.238 0.923 0.503 0.088 0.031 0.16 0.052 0.29 0.055

[email protected]