The stock market has moved very sharply in the last few days in the days when there was uncertainty about election results and economic policies. This has left many people wondering whether the market has any clue about how the economy is going to behave?
Many people think that financial markets are some kind of casino, that the ups and the downs of financial markets are irrelevant. It is remarkable to see a large number of people, including (strangely enough) market professionals who hold this kind of view.
From the 1960s onwards, the economics profession has increasingly veered towards a very different view of markets. Professional economists think that market prices reflect expectations about the economy's performance. Stock markets tend to be buoyant when the economy is expected to do well. This has been seen both since the nineties in India, and in stock markets abroad.
The price of a company's stock responds both to news about the company and about the economy in general. The market index, a weighted average of the share price of the most traded companies, reflects expectations about the behaviour of the economy as a whole. The index is a diversified portfolio. It includes companies such as oil companies, banks, software companies, etc. and is not sector specific. The only systematic factor in the fluctuations of the index is the outlook for the overall economy.
The stock market is a remarkably good forecaster. For example, in the early 1990s, stock prices rose sharply - in anticipation of a doubling of profit in 1994 and another doubling of profit in 1995. From late 1994 onwards, stock prices did badly. This was in anticipation of big declines in profit: -38\%, -22\% and -50\% from 1996-97 to 1998-99.
Similarly, in 2002-03 and 2003-04, profits grew sharply, and the stock market captured this in prices ahead of events. Any economist who made such forecasts would be extremely proud of his abilities.
In recent days, the irresponsible statements made by the left were the most damaging for the oil companies and for PSU banks. A lack of progress in privatisation of these companies bodes ill for their future profit growth, since they will continue to be subject to poor management and government interference. Hence, this turn of events led to the sharpest drop in stock prices of these companies.
Why does the market work so well? In the Indian stock market 92 percent of the trading volume is accounted for by individual retailers. Only 8 percent are the FIIs, FIs and mutual funds who hire professionals. The foundation of the market is information processing and forecasting efforts of speculators. Recently, Hindustan Lever hit a wall in terms of failing to obtain growth in profits. A speculator who had correctly anticipated this event, ahead of time, would have profited enormously when the bad results of HLL actually came out.
Unlike the employees of banks or mutual funds, individual speculators are extremely well motivated since they work for themselves. They put their own money on the line when they take positions on the market. This gives them good incentives to study companies and the economy, make forecasts, and place their bets. It is an amazing systems of side bets about what will happen next.
The author is at NCAER. These are her personal views.