IS a soaring Sensex telling you good things about the economy? Experience suggests otherwise. Since January 1997, the Sensex has surged twice; a third surge is under way. Yet, each 25-30 per cent rise in the index has flown straight in the face of declining growth in gdp and/or industrial production.
These economic woes have seen corporate profitability decline for two straight years, and a further decline for 1998-99 is certain. But through 1998-99, when net profit margins dipped from about 6.5 per cent to 5.9 per cent, the Sensex plunged from over 4,300 points to 2,741 points before leaping back 37 per cent to 3,743 points now.
But the Sensex rarely sits well with the evidence from most commonly-tracked economic indicators. For a better explanation, look at two sets of influences.
The first. Major changes in the economy fundamentally affect prices because they set the agenda for sustained growth in the earnings of those stocks. Liberalisation, for instance. It began in earnest almost a decade ago, and will continue to make or break stock valuations-just ask software and steel firms. Such changes establish the Sensex's long-term growth rate, around 20 per cent a year over the last 20 years. A fresh bout of liberalisation (deeds, not words) would bring about another phase of sustained rise in the index.
Short-term factors form the second set. Share indices zoom or plummet when the demand-supply situation for equities is disturbed by a complex interplay of factors like sops in the Union Budget (1997 and now in 1999), falling liquidity (in 1997 and 1998), sustained buying by foreign insitutional investors (1993 and 1997), or a scam and its aftermath (1992 and 1993).
For instance, lower interest rates and falling gdp growth rates pull in different directions, and the resultant fluctuations in the Sensex may be abetted by unpredictable factors like the market's mood. These short-term imbalances are influenced by several economic variables but their interplay is complex, and they certainly do not mean that the economy is headed in the direction suggested by the imbalance. Still, the markets whipsawing 30 per cent plus in weeks seems more attractive than a 20 per cent long-term return.
Another reason why economic variables needn't be the pillar of investing strategy is that the quality and timeliness of information still isn't up to developed world standards. So by the time a change in an economic variable has been established, the market has anticipated it, digested, reacted and quite possibly repented.
So for investors, the best option doesn't change: ignore the short term, and beat the market with shares of fundamentally strong companies.
