Why is the stock market rallying during a recession?
India will officially enter recession when the Q2 results of economic indicators are out since by definition, any country with negative growth for two consecutive quarters is termed to be in a recession. Well, it’s no surprise as we have already seen the 23.9% decline in Q1 of FY20 and the debate now is not whether India or say any other country will step into recession but, the shape of the recovery.
All this on one side, and you turn to the financial markets to see if they are doing okay! BUT, you are bewildered as they are performing tremendously well. This shouldn’t be as startling to witness for a pre-covid era. Why now? Why has the Nifty and Sensex bounced back so much that they might even hit an all-time high soon when the unemployment claims are raising the fiscal deficit?
Ahh, it’s a million-dollar question but with many answers! Let’s try to reason out the divergence between the Stock Market and the Economy.
Firstly, we have to answer the question of why people invest. Short answer- People invest when they have excess cash in hand which they don’t want to spend. Next, do people have excess cash in hand right now? No. Then why do they invest in the stock market now? Simply because they don’t want to spend elsewhere. This leads us to our first reason - excess money supply in the economy. Central Banks all around the world are pursuing an expansionary monetary policy coupled with the Fiscal Stimulus by the Government, similar to the curbing strategies of the Global Financial Crisis of 2008, to pump in Helicopter money in the hands of the masses to boost the spending spree in the economy. Too many technical terms, ah?
Helicopter Money - Literally denotes a helicopter dropping money from the sky. Milton Friedman used the term to indicate "unexpectedly dumping money onto a struggling economy with the intention to shock it out of a deep slump."
It’s simply by cutting repo rates and buying G-Securities in the open market which will lead to the flooding of cheap money (borrowing comes at a low-interest rate) hoping that the end consumers will spend which in turn will lead to a positive GDP Growth rate. But, since a vaccine is not in place yet, the fear due to the uncertain future does not let them spend but to invest in the stock market as they are lured in by the figures of compounding returns.
To aid the above explanation with evidence, we look at the second, more compelling reason - the GFCF – Gross Fixed Capital Formation. GFCF is a macroeconomic concept that measures the investment in real tangible fixed assets like real estate, infrastructure, factories, construction, etc. as a percentage of GDP. From the below data sourced from the World Bank, we clearly see a decline in the past decade’s value-adding spending and hence can assume that all this money is routed to the stock market due to innumerable reasons including shortage of labor (reverse-migration), global supply chain crunches (stay-at-home orders) even if there was an animal spirit who is ready to take the risk.
Thirdly, we must point out the Bandwagon Effect. You invest. I invest. My friend invests. Everybody invests. This is the Bandwagon Effect. It’s more like jumping on to the Bandwagon without knowing where it is headed. In our context, people invest due to the irrational behavior of the surrounding entering the Utopia just to know that everything will vanish in a while. Similar to the “Irrational Exuberance” phrase used by then-Federal Reserve Chairman, Alan Greenspan to denote the overvalued stock market in the 1996 speech warning for an internet bubble in the near future. This was later authored by Robert J. Shiller, an American Economist and Nobel Prize Winner to empirically prove that Irrational exuberance is unfounded market optimism that lacks a real foundation of fundamental valuation, but instead rests on psychological factors by analyzing the speculative booms that lasted from 1982 through the dot com years.
Do note, that we are talking about NIFTY and SENSEX which indexes only 50 and 30 top-notch companies in their respective sectors. This not only ignores MSMEs but also the fact that they account for 40% of total exports, 45% of total industrial production, and 37.54% of GDP. And who is the most affected due to the crippling effects of the pandemic in terms of credit shortage and other explicit reasons? MSMEs. And guess who is not listed on the stock exchanges who in turn appear to be the faces for benchmarking the stock market? MSMEs. Ultimately, this harsh truth represents the reality of the economy which is ignored by the indices. Although corporate earnings do impact the stock market, it does not move according to the ground-level reality of SME’s fallacy.
Lastly, the outperformance of FAANG stocks in the US and HRITHIK stocks in India makes a whole LOT of difference in the performance of the Stock Market. Be it technologically sound companies or E-Commerce Businesses, hardly affected by the pandemic seems to follow the Pareto principle rigorously.
FAANG – Facebook, Amazon, Apple, Netflix & Alphabet (Google)
HRITHIK - HDFC, Reliance Industries, ICICI Bank, TCS, HDFC Bank, Infosys, and Kotak Mahindra Bank Pareto Principle – Named after Vilfredo Pareto, this 80/20 rule states that 80% of consequences come from 20% of the causes. Also known as the law of the vital few, it empirically proves the existing inequality found in every sphere of life.
Always remember, Markets are forward-looking while GDP dictates what occurred in the past quarter or year. The prices today signifies the status quo as well as the anticipation of the company’s future performance. It hits the market well ahead of the company’s bottom line. Linking them partly makes sense but the markets will surely correct itself in a while. I cannot define “while”. But yes, it will when the madness of mobs turns into the wisdom of the crowd. Or maybe all this is just supporting the K-shaped recovery? Or maybe it is due to the flow of Foreign Institutional Investors (FII) money? Until then, one last reason to answer the question would be from the “Oracle of Omaha” Warren Buffett himself “Be fearful when others are greedy and greedy when others are fearful”.
By Tejaswini GB