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Does Sensex trace GDP growth?

Mar 30, 2005

The Sensex is currently hovering at 6,400 levels at the end of FY05. Where will it be four years down the line i.e. FY09? The answer is over 10,000 (10,071 to be precise)! It is not rocket science, but a simple mathematical calculation. But how easy is that? Assume that the Indian economy will grow by 12% every year (to make it clear, this is nominal growth and not real growth. If the nominal growth is 12% and if average inflation during the fiscal was say, 5%, then the real rate of GDP growth is 7% (12 minus 5). Since corporate performance tends to trace GDP growth over the long-term (very important assumption) and 'if' stock market follows suit, compound the current Sensex level by 12% over the next four years and you get the Sensex target for the future!

But, before you buy this argument, we would like to highlight some pitfalls in these assumptions by presenting the last ten year (FY95-FY04) performance of the Indian economy, the corporates and the Sensex. The objective is to analyse whether there is any co-relation at all. Here are the facts to start of with.

History speaks for itself...
  FY95 FY96 FY97 FY98 FY99 FY00 FY01 FY02 FY03 FY04 CAGR**
Macro indicators
Nominal GDP
growth
17.4% 17.0% 15.9% 11.8% 15.0% 10.2% 8.0% 9.9% 7.8% 11.7% 11.9%
Real GDP
growth
7.3% 7.3% 7.8% 4.8% 6.5% 6.1% 4.4% 5.8% 4.0% 8.5% 6.1%
Quantum
sales growth
29.6% 23.3% 19.0% (4.3%) 14.2% 23.4% 23.5% 0.7% 11.9% 11.4% 11.9%
Stock market
BSE Sensex* (13.7%) 3.3% (0.2%) 15.8% (3.9%) 33.7% (27.9%) (3.7%) (12.1%) 83.4% 6.2%
BSE-100 (12.2%) (3.5%) (5.5%) 15.9% (2.7%) 75.8% (41.7%) 1.4% (12.5%) 97.6% 7.1%
BSE-200 NA (6.3%) (4.9%) 14.9% 0.8% 63.9% (41.1%) 7.4% (8.9%) 104.3% 8.0%
Source: RBI and Equitymaster database.  *as on March 31st  **9yrs

First the good news. If one takes the last nine years CAGR (compounded annual growth rate) of real GDP and the performance of the BSE Sensex, yes, there is a clear co-relation. While real GDP has grown at 6.1% during this period, the Sensex has also posted similar gains. More importantly, the consolidated net sales of Quantum Universe has risen by 11.9% in the last ten years, which is at par with the nominal GDP growth rate. So yes, the argument is good enough and we concur.

But look a little deeper and the finer picture emerges. Even as the real GDP growth has been growing at a steady rate on an annual basis in the last ten years, the BSE Sensex has had a very volatile trend. On a year-on-year basis, there seems to be no sync at all between these two factors. However, if one considers the growth in nominal GDP and the corporate performance at the topline level, there is a fair degree of co-relation. This is because, GDP of the economy is the collective output of the agriculture, industrial and services sector, which is fairly represented in the Quantum Universe. Given this backdrop, investors may be better off if some following aspects are borne in mind before venturing into such predictions.

  1. In the long-term, may be: Economy goes through cycles of recovery, peak, slowdown and depression over the longer period of time. Similarly, Indian stock markets also have cycles, depending on how the economy is performing. Therefore, even if India's GDP grows at 12% in one year, the Sensex may not gain a similar percentage during the year. However, the relationship may hold true over the longer-term. Even here, there have been periods in the US economy in the last century wherein there has been a very weak link between economy and stock market performance.

  2. Sensex at over 10,000! So what? Even if the Sensex manages to achieve such targets, what does it mean in the end to the investor? It does not answer which company's share does one buy from a long-term perspective. It is only good if you are a buyer of an index fund and is happy with a 'probable' 12% return per annum. Besides, 'what is hot' and 'what is not' changes over a period of time. The erstwhile bluechips like Century Textiles, Arvind Mills, ACC, Bombay Dyeing are no longer 'preferred' by investors. So, it is pertinant to understand that the benchmark indices only reflect market sentiments and the overall state of the economy. Taking buying/selling decisions just based on an index level is fraught with risks.

  3. There is something called as sentiment: Stock markets are not only influenced by fundamentals but also by sentiments. For instance, lowering of interest rates by the RBI (like until 2004) typically has an impact on the economy with a lag. But the signal that the RBI is reducing interest rates may prop up stockmarkets immediately and stock prices may react much faster. Another example of sentiments playing a key role is the interest level in Indian equites, like say between 2001 to 2003. Even when valuations were extremely attractive, markets lacked in depth because of weak sentiments. There are other risks like stock market scams (we have had three major ones in the last ten years) that impact markets.

  4. What value to assign?: Like the stock price is a factor of EPS and value multiple (called as price to earnings ratio), the index is a function of combined earnings of index stocks multipled by the value multiple. What valuation the Sensex deserves is again subjective. One could take the growth in nominal GDP at 12% as a valuation multiple i.e. P/E, whereas a high risk investor would be willing to pay even 20 times for the combined earnings of Sensex companies. While there is no definite answer to this one, investors have to bear in mind that in a bear market, even if GDP grows, the stock market may not reward the performance. Here the co-relation may turn weaker.

To conclude, while we believe that fundamentals dictate stock market directions over the longer-term, there are pitfalls in such assumptions, which one has to acknowledge. This is perhaps one of the key reasons why investors could adopt a long-term strategy while investing in stocks. Assuming that a company 'X' is likely to grow earnings at a certain rate, the stock market may take time to reward adequately. But over a period of time, markets will catch up. Patience is the virtue of the game, as far as serious investors are concerned.


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1 Responses to "Does Sensex trace GDP growth?"

vibhor jain

Nov 6, 2015

jain-Would be good if you could revisit this correlation as economy took 60 years to reach trillion mark, 7 more years to 2 trillion and likely to race to 5 trillion in 5 more years. This will give a realistic empirical peek on effect of growth on Sensex and likely projections as well. Thanks.

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