The Disconnect between the Stock Market and the Economy

The stock market and the economy are moving in opposite directions. As the stock market witnesses one of the best rebounds globally, the economic outlook remains gloomy. The disconnect between the two is said to be the largest in India— the country having the world’s second-highest number of coronavirus cases.

To put things into perspective, here’s a graph showing the contrast between India’s $1.9 trillion stock market and the real economy:

The graph shows that the investors have been skipping the grim economic outlook as the valuations of the stocks sky-rocket. The S&P BSE SENSEX is the benchmark of India’s BSE, and it comprises 30 of the largest and most actively traded stocks on the BSE, providing a gauge of the Indian economy. Ironically, the SENSEX has been soaring while the Indian economy glooms, indicating a disconnect between the two.

The Current Economic Outlook:

As India and the rest of the world slip into a recession, the latest figures indicate a -23.9% growth in Indian GDP (QoQ), while the unemployment rates have been rising. As per the data released by the CMIE, the urban unemployment in India shot up to 9.83 per cent in August, increasing rapidly from around 7.22 per cent and 7.76 per cent in December to February. Economists suggest that urgent government intervention is required to pull out the economy.

The IMF predicts the world GDP to shrink by 4.9 per cent in 2020. India’s GDP growth forecast has also been cut by 4.5 per cent in 2020. However, a sharp recovery is expected in 2021, with the IMF projecting the Indian economy to grow at 6.0%.

Reasons for the Stock Market Rally:

The RBI Governor, Shaktikanta Das, feels that excess liquidity in the global system is fuelling stock market exuberance. According to him, liquidity in the global economy is the cause of buoyancy in the stock market, which is disconnected from the real economy. It will certainly witness correction in the future. But when exactly the correction will take place is hard to predict.

The other reason for the disconnect might be that the stock markets are forward-looking in nature and are expressing optimism that the pandemic would end with a vaccine. However, the economy is backward-looking. Thus, by the time this kind of economic behaviour factors in economic shocks, the stock markets have already priced them.

Moreover, a few stocks dominate the market. This implies that while some companies may be benefiting from the current scenario, others might not. However, the benefitting companies overshadow the impact of the non-benefiting companies. This was true in the case of the USA. S&P 500 is a gauge of the large-cap U.S. equities, consisting of 500 largest U.S. publicly traded companies. The major gains to the S&P 500 and other indexes were attributed to the technology stocks like Apple, Microsoft, and Amazon. These stocks gained because the investors estimated their swift transformation to stay-at-home as their strength.

This disconnect is observed globally. According to a research firm, stocks in the USA have moved higher in seven of the past twelve recessions, dating back to World War II, with a median advance of 5.7%. So while the underlying economy is weak and slowly recovering from the sharpest decline since the Great Depression, don’t be surprised if the stocks continue to hit a record high.

What happened in the Great Depression?

Post 1918, as the World War ended, more and more people started getting employment and the incomes of the people increased rapidly. The banks were extending loans and spending in the economy was high, consequently the revenues of the companies were also increasing. People were wondering what to do with their newfound income and started investing in the stock market. As more people were buying, investors found it easy to make money in stocks. By 1929, investments were up by 218% since 1922. The stocks were rising so fast that the companies were having a hard time justifying their stock prices.

However, as the stock prices soared, the companies realised that the production was not increasing. When companies realised that they had overestimated their growth, the wages started falling. However, despite the economic shocks, the stock market seemed unaffected till 24th October 1929, also known as the Black Thursday, when the prices of the stocks started crashing and 12.9 million shares were sold. Many had lost their life savings and the economy was shattered.

Essentially, a stock market bubble build-up had happened. This happens when the link of the stock market with the real economy (macroeconomic and business fundamentals) is broken and the prices of securities rise far above their true value. Doesn’t this resonate with what is happening currently? While the economic outlook is gloomy, the stock markets are booming. This seems to suggest that the stock market is entering a bubble, which when broken would affect the entire economy, especially the retail investors.

Are we approaching the Great Depression?

All the indicators seem similar to what happened in 1929-30. The economy was crashing, people were losing their jobs, wages were going down, but the investors kept investing in the stocks. Even today, due to the pandemic the unemployment rates have been increasing, the economic indicators are grim, with a huge decline in GDP. The RBI has been decreasing the repo rate. All this indicates that the stock market is entering a bubble that might burst at any time. It wouldn’t be a surprise that as the economy continues to contract, stocks might reach their all-time highs.

Ashu Jain is a second-year student at Ashoka University pursuing a major in Economics and Finance.