Is the Stock Market A Reliable Economic Indicator?

After the alleged coup of the PTI regime, the bulls of Chundrigar Street were joyous of the 1,700-point gain in the KSE-100 index on April 08. Marked by praises for the new Shahbaz Sharif-led regime by the supporters, the bull market landed into controversy over whether the stock market is a good indicator of economic health or not. A rise-or-raise debate extends.

One has to look beyond political rivalries to answer the above question. Financial analysts, let alone political factions, also hold polarized viewpoints. It creates a deadlock. One way to eliminate this deadlock can be to assess the stock market performance in crisis-hit countries.

Stock Market vis-à-vis (Financial/Political) Crises Sri Lanka

Recently, one of the most talked-about financial crises is the Sri Lankan crisis. While drafting this, Sri Lanka warns of defaulting on its foreign debt. The financial crisis formally began in 2019 before the pandemic. The pandemic only worsened it. Despite the ongoing economic turmoil in the island nation, Sri Lanka’s second-largest capital market, aka the equity market, broke previous records and exceeded the 11,000-point mark. It occurred on November 16, 2021. The very same day, thousands of protestors took to the streets of Colombo against the perpetrators of the crisis (the incumbent government).

The US

Another crisis, this time a (purely?) political one, occurred in the self-proclaimed vanguard of the global democracy, i.e., the United States. The pandemic, numerous deaths, the murder of George Floyd — a person of color, and the resulting protests created unrest when Donald Trump was in power. However, the stock market soared frequently. Chris Brown of Aristides Capital, a hedge fund, termed it “ cognitive dissonance.”

Cognitive dissonance refers to a psychological phenomenon of a conflict stemming from two opposing thoughts originating in and emerging from the same human mind. Consider the following general example wherein four possibilities emerge from two opposing cognitions:

If you are into reading finance-related news, you might have come across the phrase “pumping money into the market.” It also refers to financial injection. One of the prime reasons for the stock market boom was the injection of dollars by the Fed, as Vox reports. Jeff Madrick, Director of Policy Research at the Schwartz Center for Economic Policy Analysis, also says:

“The current stock run-up, which has reached new highs, is first, and most importantly, due to the Federal Reserve injecting massive amounts of stimulus into the banking system.”

Pakistan Stock Exchange (PSX): Background Information

Pakistan Stock Exchange, PSX for short, comprises Karachi Stock Exchange (KSE), Lahore Stock Exchange (LSE), and Islamabad Stock Exchange (ISE). As of April 12, 2022, 555 listed companies in 37 sectors with a total market capitalization of more than Rs. 07 trillion exist, out of which the KSE-100 index alone constitutes 85 percent.

A wide disparity exists in the KSE-100 index. Despite the listing of more than 500 companies, merely 31 families deeply influence the exchange market.

Coming Back to Pakistan

The closing paragraph of The US is reminiscent of the recent State Bank move. Financial injection of Rs. 3.37 trillion by SBP in the money market through open-market operations (OMO) is one of the reasons for the stock market boom.

The money market refers to the financial market type wherein tradeable securities mature in less than a year. Since the maturity period is relatively shorter, such instruments offer less risk and less yield.

However, it should be a no-brainer that the opening paragraph of this section does not serve as the only reason for the bullish trend. Financial markets are inherently complex, and multiple factors influence them simultaneously and sequentially.

Global Trends

The recent PSX boom is nothing miraculous. Historical evidence reveals that the imposition of a new government results in a bullish trend and, in several cases, the domestic currency appreciation. The author cites examples of such phenomenon:

• Turkey and Erdogan: The stock market boomed, and the Turkish Lira appreciated after Recep Tayyip Erdogan regained a majority in the Parliament, as per NYT and Bloomberg.
• The US and Trump: Dow Jones went bullish after Donald Trump became the President.
• The US and Biden: Stocks soared after the victory of Trump’s arch-rival.
• Pakistan and Nawaz Sharif: PSX gained as the now-disqualified Nawaz Sharif neared victory.
• Pakistan and Imran Khan: The stock market soared as Nawaz Sharif’s arch-rival approached a win in the elections.

Conclusion

From the above points made by the author, one can conclude that the stock market is not a good indicator of the economy. Mark Mobius, acclaimed as the “Godfather of Emerging Markets” by Reuters, writes:

“The stock market anticipates a coming economic change and may decline if an economic downturn [comes] and may increase if the economy is expected to improve.”

However, Jeff Madrick disagrees with Mobius on the ‘anticipation’ thing. According to the latter, the anticipating property of the stock market makes the stock market a leading indicator. On the other hand, Madrick does not think of the stock market as a leading indicator. He says:

“This idea that the market is an indicator of the future and closely linked to the real economy is mostly a myth. To say that stocks rationally and accurately reflect the future (as some analysts and academics insist they do) is not just a naïve notion, but a dangerous one.”

Paul Krugman, a Nobel laureate, asserts that the stock market and economy are non-related.

Originally published at https://rafeyirahman.substack.com on April 13, 2022. If you liked this or learned something new, please consider subscribing to Finesse for more financial literacy posts.