Sensex up, but not the sentiment

Indian Express, 11 June 2005

MANMOHAN Singh might be the first head of state in the world who owes his job to the stock market. The sharp drop in the stock markets on May 17, 2004, when there were fears of Leftist ideas driving economic policy, served as a wake-up call. This may have pushed the choice of Manmohan Singh to head the government and P Chidambaram as Finance Minister.

As report cards on the UPA’s performance fill newspaper columns, we ask a narrow question: has the UPA’s team of economic reformers delivered, in the sense of giving optimism about the future of the country. At first blush, it seems that they have. India is the flavour of the month. There are conferences galore on India and China. Companies have performed well and growth of economic indicators looks impressive. The stock market has moved back up.

However, when we look more carefully at the behaviour of the stock market we find that optimism about the growth of the economy improved only until December 2004. It has declined again after the extent of Left involvement in economic policy has become clear. Today, optimism about India’s economic growth is just barely higher than it was one year ago, in the depth of political turbulence.

Let us turn to the details. From the depths of 17 May 2004, when the stock market index (Nifty) dropped to the level of 1388, there has been a comprehensive recovery of stock prices, to the present level of 2100. Why did the stock price index rise by 50%, and how should we interpret this rise?

The value of a company on the stock market is best viewed as a two-part story. When the stock market looks at a company, the first question is about how much profit the company is making today. The second question is about how fast the profits are expected to grow in the future.

A fast-growing pharmaceutical company and a sluggish steel company might have the same profits, but they will command very different valuations. The stock market pays more for a company where rapid growth is expected in the future.

For example, Tata Iron and Steel Co. (TISCO) and Ranbaxy Laboratories Ltd. are both currently valued at about Rs 20,000 crore. But they have come to this in very different ways. In 2004-05, TISCO earned Rs 3,374 crore of profit, while Ranbaxy earned only Rs 466 crore of profit. Yet, the stock market has chosen to value the two companies alike. The difference lies in expectations about future growth, in optimism about how the two will fare in the next five or more years.

Dividing the market capitalisation upon the profits gives us the Price Earnings ratio or ‘‘the P/E ratio’’. In our example, TISCO has a P/E of 5.7. Ranbaxy, on the other hand, has a much higher P/E of 44. This shows that the stock market expects higher profit growth from Ranbaxy.

It is generally thought that the stock market index reflects expectations about the future. But this is not a correct interpretation of the level of stock prices. Stock prices can grow because profits go up. It is important to make a clear distinction between stock prices and the P/E. If we want to know the optimism of the stock market, or the expectations about future economic growth, then we should be looking at the P/E and not the level of stock prices.

The P/E can be computed at the level of a company, an industry, or the overall stock market index. The P/E of the market index reflects the growth prospects of a range of companies, across many different industries. The Nifty index contains companies of all major industries in India, including oil, banking, software, consumer goods, automobiles, steel, etc. The future earnings growth of Nifty as a whole predominantly depends on India’s GDP growth. The P/E of Nifty hence reflects what the stock market thinks about future macroeconomic growth prospects for India.

The story from early 2004 onwards can be broken down into four phases.

Stage I: In early 2004, when Nifty was at levels like 1982, the P/E of the index was at a high value of 21.86. This suggested significant optimism about the future.

Stage II: In April 2004, especially after the sari stampede incident in Lucknow, expectations about election outcomes became confused. There was a sharp drop in optimism. The P/E of Nifty dropped sharply from 21.6 in early April 2004 to 15.7 by May 11. By May 13, the P/E had fallen to 14.6 and on Black Monday it fell to 12.8. The index dropped from 1982 in January to 1388 on 17 May.

Stage III: On May 22, 2004 Manmohan Singh was announced PM. On May 24, Chidambaram was announced FM. On June 16, Montek Singh Ahluwalia came in as Deputy Chairman of the Planning Commission. From June 23 onwards, the stock market turned around. Manmohan Singh’s choice of Montek Ahluwalia strongly suggested that the Left was not in charge. Optimism improved considerably. The UPA got it’s honeymoon period. For many months the market believed that the new trio would deliver sound economic policy. The Nifty P/E, cautiously optimistic, climbed back to 15.57 on January 3,2005.

Stage IV: The honeymoon ended in January. Looking back to December 2004, one announcement after another indicated that while the team might be good, it did not have the power to deliver. As former Chief Economic Advisor Shankar Acharya said in an article titled ‘‘Bad ideas are winning’’ in December 2004, in the tension between good men and bad ideas, ‘‘bad ideas seem to be trouncing good men’’. Left leaders declared that the PM had promised higher interest rates on EPF. The power ministry was told to review the Electricity Act. The controversy about Press Note 18 showed that reformers were not in charge. Labour reform, restructuring of the public sector and infrastructure, pension reforms, and financial sector reforms were put on the backburner.

We see that over the last year, Nifty has indeed recovered more than 50%. But the bulk of this increase has just come from higher profits of companies. The P/E of the index, which reflects confidence and optimism about the future, is roughly as gloomy about the future as it was in June last year. If the P/E of Nifty was 21 today, instead of 14, then Nifty would be at 3000 instead of 2000.

Since the rise in the market index is slower than the rise in profits, it shows that stock market appears to be increasingly worried about the UPA’s ability to execute sound economic policy, and obtain high economic growth. The P/E of the index dropped sharply from 15.57 in January 2005 to the existing level of 13.73, lower than the P/E on the very next day after Black Monday, May 18, 2004, when it stood at 13.94.

Looking forward, if the expectations of the stock market play out correctly, then profit growth of the corporate sector will slow down in 2005-06 and 2006-07, as compared with the hectic growth in profits which was observed in the period from 2002 to 2005. Low P/E values for firms will generate lower investment. This runs counter to the claims of the UPA government about a fine outlook for economic growth.

Ila Patnaik

Ila Patnaik