Stock market indices say little about economic growth

livemint.com:

Stock markets are an enigma from which there is little escape. At times, it seems as if the S&P BSE Sensex and NSE Nifty have become synonymous with everything that is happening in the country, including events that transcend the economy. High readings of the purchasing managers’ index (PMI) are routinely interpreted as a sign that the economy is buoyant, and this leads to stock-index gains.

Surprise news on election outcomes or of tighter capital norms for lending applied by the bank regulator can create an upheaval as share prices respond. These are micro responses that are discussed endlessly in the media on a daily basis. But the bigger picture often painted relates to the state of the economy.

It is often assumed that a rising stock index is indicative of broad confidence in the economy and acts as a foreteller of its performance. How far is this true? A stock index represents the shares of a specific set of companies. The Nifty’s formula includes 50 such firms.

Therefore, when the Nifty moves up by 5%, say, it is akin to saying that the cumulative market value of the shares of these 50 businesses has risen by 5%. This being so, using this metric to represent the entire economy is an overstretch of the logic of representation. The economy is much bigger than these 50 firms (30 in case of the Sensex).

Even indices that include the country’s top 100 or 500 companies cannot represent all commerce across the economy. While the market value of these businesses is very large and all big news developments that impact the economy also tend to affect these indices, at least for a few trading sessions, they do not form any kind of representative sample. Those who swear by markets are usually driven by Adam Smith’s version of