The stock market is not an accurate indicator of the economy. If you’re on twitter you’ve probably read this scribe tweet about it often enough – at times ad nauseam even. Whether you agree or disagree to the statement widely depends on a number of reasons.
Before we get into details and talk about whether or not the stock market is an indicator of the economy, let’s talk about what politicians say. It’s simple. If you’re in government and the stock market index goes up taking credit for it seems like the best thing to do because optics. If you’re in opposition and the market goes down, you could say that the government is doing a terrible job at managing the economy and it is reflected in the index’s performance.
Our argument, which also happens to be true by the way, is that whether the stock market goes up or down it says absolutely nothing about how the economy is doing. It does say how people think the economy is doing, but that is a pretty big and pretty significant detail. However, before we debate on this concept, let’s get some concepts straight, and to do that let us answer some important questions.
How do you define an economy?
A textbook definition is that an economy is the state of a country or region in terms of the production and consumption of goods and services and the supply of money. In order to understand how the economy is performing we use a number of indicators. These indicators are pieces of economic data. They are usually macroeconomic and not microeconomic.
Macroeconomic data is basically data for the aggregate economy. This means large scale data such as the total number of cars produced in an economy in a year. Microeconomics, in contrast, is on a smaller level – as the name suggests. For instance, the number of cars produced by a single manufacturer in a year. Another example to understand this better could be the total money spent by the government in a year is concerned with macroeconomics; while the total money spent by your family in a year is concerned with microeconomics.
What do we mean by economic indicators?
There are a number of economic indicators. Essentially investors or analysts can use any indicator they deem relevant to the research they are undertaking. However, some indicators are widely used as they are released by the government or dedicated organizations. For instance, the consumer price index, gross domestic product, unemployment rates, debt, exchange rate, risk premiums, budgets, current accounts, interest rates, gold and oil prices, and stock market indices.
Some of these indicators work hand in hand with the economy without lag, some have impacts on the economy in a lag, and some are impacted by the economy with a lag. For instance, the GDP is an indicator of the economy. When the GDP grows, in crude terms the economy has grown too. To refine this, we look at real GDP instead which is inflation adjusted GDP.
Similarly, interest rates have an impact on the economy. When interest rates are higher, output growth slows down as investment slows down. In contrast, the stock market as an indicator is debatable and also depends on a variety of factors.
What is a stock market?
The stock market can also be called a stock exchange. Essentially, when you’re buying a share on the stock market you’re buying the ownership of shares in a corporation. Similarly, when you’re selling shares, you’re selling your rights to ownership. Incorporated companies list on the stock exchange to raise money.
What this means is that the stock market is composed of buyers and sellers of shares. This does not represent all businesses, employees and households. People use indices to understand how the market is performing.
What is a stock market index?
A stock market index is an index that measures a stock market. It helps investors compare current price levels to the past as a gauge of market performance.
In Pakistan we have the KSE 100 index, KSE 30 Index, KSE All index, KMI 30 Index, and KMI All index. The KSE 100 index is a stock index that is used as a benchmark. 100 companies with the highest market capitalization are chosen. In order to make it a greater representative, the company with the highest market capitalization from each sector is also included. Approximately 90% of market capitalization is represented by these companies.
The KSE 30 index on the other hand only represents the free float of shares rather than using paid up capital as a determinant. Top 30 companies participate in it.The KSE All Index is an index used to show changes in all the stocks listed on the PSX.
The KMI 30 index is called the KSE Meezan Index. These companies listed in this index are Islamic Shariah Compliant. It was introduced in 2009. At the time, the Karachi Stock Exchange (now PSX) and Al Meezan Investment Bank (now Meezan Bank Limited) created the index. It is calculated on the basis of free float market capitalization. The index reflects the free float market value of selected Shariah-compliant shares in comparison with the base period. KMI-30 is recomposed semi-annually. Some day we’ll write an ELI5 on the KMI index and the criteria.
So does the PSX accurately represent the economy?
If you don’t want to read ahead, let’s make it simple for you. No. it doesn’t. While there have been many papers written about the relationship between the stock market in general with the economy, and the PSX and Pakistani economy specifically, we’re going to list a few simplistic reasons. There are, of course, more. In case you don’t buy it, here are the major reasons why the PSX cannot be taken as an accurate indicator of the economy.
Reason 1:
The PSX market capitalization to GDP stands at 17.39% in FY21. It was around 43% in 2007. What this means is that the country’s output has grown while the PSX’s contribution to the output has shrunk.
Reason 2:
The stock market does not represent all the companies that make up the Pakistani economy, especially considering the size of the informal sector. The market is largely made up of corporations that are larger and have access to broad capital markets which not all small companies do. If we talk about Pakistan, agriculture remains a huge source of employment, most of which is in the informal sector and is not listed on the market. However, spillover effects happen, such as employment generation through the demand created by the companies listed on the PSX.
Reason 3:
The money invested in the PSX is somewhat concentrated in a few hands. For instance, big conglomerates have multiple companies listed on the PSX. Top 12 groups in Pakistan own around 41% of the total value of the PSX. That is how concentrated the market is.
Reason 4:
Investors do not always rely on fundamentals to invest in the PSX. They may be driven by emotions or speculation. Their behavior may not always go line in line with the economy’s performance and current affairs. The market isn’t really the most rational place in the world. Had it been rational, we wouldn’t have seen market crashes or markets rallying for no apparent reason.
Reason 5:
Bubbles exist. Individuals, institutions and the government should stay weary of speculative bubbles, especially when there are no other strong economic indicators to back this.
A recent example of this is from 26 May 2021 when the PSX saw an all time high daily trading volume. The government was quick to take credit and make it seem like the economy was booming. However, a deeper look into the trading showed that it was indeed not the economy that was pumping up volumes. Out of a volume of 1560 million shares, 707 million were added by Worldcall Telecom Limited making up almost half of the total intraday volume. Volume was witnessed in WTL considering the recent news of an acquisition or an alleged pump and dump. Now tell me dear reader, does that mean the PSX and the economy are highly integrated?
Reason 6:
There are a handful of investors. There are only 252,322 unique investors on the PSX as per data by NCCPL. 12,356 are foreign accounts. How can the PSX be an indicator of the economy when it doesn’t even engage a significant proportion of individuals?
What does all of this mean?
We’re not saying that the PSX has nothing to do with the economy. Ofcourse, when the economy is performing better there is usually more activity on the PSX. However, we’d like to say that the PSX is better at explaining or representing what investors expect in the future or how they feel about the present. It could be used as an indicator of expectations or sentiments. However, even with that the indices may not be a true representative.
The good thing is that in economics, there is always room for proxy variables in the absence of true indicators.
