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India's Third Giant Leap

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Stock markets no longer a barometer for economy
Fri, 5 Nov Pre-Open

Stock markets no longer a barometer for economy Stock markets are theoretically a barometer to check the economy’s health. It prices in information, whether real or rumored. So if the economy is doing or is expected to do well, then stock markets typically reflect the buoyancy and vice versa.

However, in recent times, this relationship seems to be breaking apart particularly in the emerging markets. Since June this year, MSCI emerging markets (a broad index for measuring emerging market stocks) has run up by nearly 25%. During the same time, Indian markets have gone up by 24%, Chinese markets up by 19%, Brazil by 16% and Russia by 17%.

Source: Yahoo Finance, Bloomberg
Countries are representative of their respective benchmark indices

So what is leading the gains in these countries? Have their fundamentals changed so phenomenally in the past four months? Not really.

The emerging markets definitely have an edge over the developed world in terms of fundamentals. Their GDP growth rates are high and expected to get higher. They are not reeling under the weight of recession like their western counterparts.

However, we ask ourselves, isn’t this already priced in into the stock prices? Then why have the markets been going up? The answer is the capital flows from the foreign institutional investors (FIIs). In the absence of attractive investment opportunities in their home countries, these investors are flocking to the emerging markets. That in turn has led to spectacular run-ups in the emerging market stock prices. This flow has been further magnified with the news of quantitative easing and austerity measures adopted by some countries in the West.

While some may say that this just confirms the ‘emerging market growth story’, we feel that this is more of a temporary phenomenon. The prices have to match or justify the underlying fundamentals. At some point of time, the prices will stop justifying the underlying fundamentals. And at that point, these markets will start ‘correcting’ downwards. We cannot tell you when that will happen. But there is a high degree of possibility of the correction unfolding sometime in the near future.

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