Ever since the general elections, the stock market is on a roller coaster. The sensitive index, reacting to every conceivable news and half news, is moving sharply up and down and the finance minister, in a desperate move to win the confidence of the market, is making frantic statements to the business community and quick trips to business districts. The earnest efforts of the finance minister would suggest that stability in the stock market is of utmost importance for a smooth functioning of the economy and the welfare of the citizens. It would also imply that the stock market is a true mirror of what is going on in the real sectors of the country. Indeed, the importance of the stock market seems to be too obvious to question.
The heretic, perhaps at the cost of being obstinate or foolish, may still ask: is the stock market really that important' If so, what are the channels through which the stock market affects the common man' After all, only a negligible fraction of the population directly participates in the process of buying and selling stocks. How do stock prices affect our fates then' Is there a hidden but inescapable link between economic prosperity and soaring stock prices which is not visible to the naked eye' Or is the current obsession with the stock market rather unwarranted'
Let us start with the basics. Theoretically, the stock market is supposed to play an important role in the grand scheme of economic activities by mopping up resources from savers and making them available to investors. A firm, by floating new stocks in the market, can raise capital, which is vital for its growth and development. Therefore, a vibrant stock market with high stock prices helps the investor raise capital with greater ease. This in turn increases economic activities, creates employment and improves welfare of the people.
At what price can a firm sell its stocks' Theoretically, the stock price should depend upon the expected future profits of the firm as well as on the volatility of these profits, as perceived by those who are buying the stocks. Now, if potential buyers of stocks think that the future of the economy is generally bleak and prospects of future profitability of firms are generally low, stocks in general will fetch low prices at present.
Alternatively, if most buyers expect that the economy has excellent prospects and firms will make good profits in future, current stock prices will go up. In short, theoretically stock prices should depend on market fundamentals and in particular on the expected dividends to be received from the stocks. If market fundamentals are weak, stock prices are low, if they are strong, stock prices are high.
Is the converse also true' Can we presume that whenever stock prices are observed to be low, future prospects of the economy are bleak and whenever they are high, future prospects are excellent' We shall argue that the converse is not true in general. The crux of our argument is that market fundamentals are just one of the determinants of stock prices in the short run. There are other determining factors as well, and so, even if fundamentals remain more or less the same in the short run, stock prices may change due to other factors. Therefore, at least in the short run, a change in stock prices does not necessarily imply a change in market fundamentals.
In the longer run, however, when short run fluctuations cancel out against one another, market fundamentals emerge as the unique determinant of stock prices and so stock prices become a better reflector of the economy.
To develop our argument further, we need to have a description of the type of players operating in the stock market. At the risk of some over-simplification, we can identify three broad types of players, small investors, large institutional investors and brokers, engaged in sales and purchase of stocks. Small investors are mostly speculators, primarily interested in buying low and selling high, thereby making a profit. Usually these investors are not directly interested in the dividends associated with the stocks.
But indirectly they are, as long as dividend payments affect stock prices. It is the institutional investors, like the Life Insurance Corporation, the Unit Trust of India or the different mutual funds, who are more concerned with dividends. Ignorant small savers enter the stock market through these institutions and these small savers have to be paid a return on a regular basis. Clearly, such regular payment has to be partly based on the dividends received by the institutional investors on the stocks they hold. Therefore, if the institutional investors believe that future dividends of certain stocks are going to be low, they will try to offload those stocks in the market. Since institutional investors make up a large chunk of the market, their expectations or apprehensions do matter in the formation of prices. The third category of agents, namely the brokers, are basically middlemen facilitating sales and purchase of stocks, but most of the brokers are engaged in speculation as well. Brokers may vary from the very small with no market power to the very large with significant market power.
Now suppose there is a change in the political regime with an associated change in the focus of economic policy. In particular, suppose that the new government is expected to take a more interventionist stance and, in some quarters, this has created an apprehension that profits and dividend payments of firms are going to be lower in future. From this, some agents, small investors, brokers and the like, might infer that institutional investors will offload some of their stocks in future leading to a fall in future prices. Therefore, arbitrage will induce these agents to offload their stocks now, though they do not care about dividend payments directly. This will have a magnified effect on current prices. An individual investor will think that everyone else would be offloading stocks, which would lead to a fall in prices, and so he himself would also be forced to offload. But if each investor argues in a similar way, then there would be a real downward spiral in stock prices.
Note that in the above example there was hardly any real basis for a market crash, for the expected fall in future profitability could be very small and in any case the fall in future profits was more of a presumption than reality. The moral of the story is that a small expected fall in future prices might have large and magnified effects on current prices through speculative attacks. In other words, in the short run there could be large changes in current prices without significant changes in market fundamentals. The stock market need not necessarily reflect the real economy.
There is a deeper problem though. Stock market transactions typically involve buying and selling of old stocks. Public issue of new shares is a relatively rare event. Even in a period when stock prices are swelling, there is no guarantee that new issues would be forthcoming. But only new issues represent capital formation, expansion of the real economy and increase in employment opportunities. So swelling stock prices cannot, per se, cause an economic expansion. They could even coexist with economic stagnation. However, they do signal, more often than not, speculative bubbles or crashes. We have had a few of these occasions in the past. We know that they are not desirable, because they reward large manipulative agents and punish tiny and uninformed ones. Why is the finance minister so concerned about wooing the stock market then'