Economic Times 17.11.

2010

What drives stock indices? A reality check

Madan Sabnavis
Chief Economist, CARE ratings. Views expressed are personal

THE Sensexor Nifty is taken to be a barometer of the overall level of economic optimism
wherein good news or adverse shocks get factored. The India shining story is often linked
with the reflection seen in these numbers. At the same time, sceptics hold that the market
is sentimentdriven and hence, at times, even good news on the economy front can be
overwhelmed by random events. The market buzz on hiking of interest rates could lead to
a decline in the market when economic conditions are otherwise sanguine. What really is
the true picture?
The right way to go about this exercise is a regression analysis looking at changes in
the Sensex and juxtaposing them with economic variables which prima facie have a
bearing. The variables that can affect the market mood are growth in credit, industrial
growth, capital issues, inflation, FII investments, exchange rate movements, changes in
forex reserves and mutual funds investments. The period chosen is from April 2006 to
September 2010 and data has been reckoned on a monthly basis. This takes care of the
day to day aberrations in the stock market movements. It has been noticed that even on a
daily basis news affects the Sensex only momentarily which is generally mean reverting
by the end of the day.
The multivariate regression model gives some interesting results. The first is that
growth in credit, industrial production, exchange rate and changes in forex reserves do
not really affect the Sensex. In fact, industrial production growth has a negative effect on
the Sensex (though it is not significant, meaning the relation is spurious). The sign is also
negative for the exchange rate suggesting that a falling rupee pushes down the market
mood. Usually one would associate credit growth to mirror industrial buoyancy, but when
it comes to the market, it doesn’t really matter.
How about the significant variables? The other four variables are significant. Higher
inflation actually pushes back the Sensex and goes with a negative sign, which makes
sense. But it questions the thought that the stock market buffers one from inflation.
Primary issues have a negative relation with the Sensex, which is not what one would
expect as the two are expected to move in consonance as IPOs become more visible when
the market is on the rise.
The other two important variables are net FII and mutual fund investments, which have
coefficients of 0.003 and 0.00097. A net inflow of $1 million of FII funds leads to
0.003% increase in the Sensex or $1 billion implies 3% increase in the same. The impact
of mutual funds is more muted with the coefficient being 0.00097. While these numbers
by themselves are not sacrosanct, the major takeaway is that these four variables explain
48% of the variation in the Sensex, also called the coefficient of determination. What
does this mean? This implies that roughly half of the variation in the stock indices is
driven by economic factors, while the rest is guided by sentiments that cannot really be
explained. Therefore, when we talk of market sentiment which is positive or negative, it
is really a collection of different trading thoughts that are not amenable to statistical
calculation. The implication is significant as it also means that we should not get swayed
by this index in terms of being reflective of something dramatic in the economy. Maybe,
this is why the stock market gyrations are often associated with the human emotion of
exuberance — albeit irrational, when things move downwards.
The other important metric that can be examined within the world of econometrics is
causation. While FIIs and mutual funds appear to be drivers of the market in statistical
terms, is it possible to say that they cause the Sensex to move? The Granger Causality
tests carried out do not show a relation either ways — FIIs or mutual funds causing the
Sensex to move or the Sensex causing these flows to expand or contract. What all this
means is that the stock market movements will remain an enigma for the statistically
minded investor where economic fundamentals explain part of the story, while the rest
will remain the proverbial mystery.