Economic Fundamentals and the

Stock Market

Security Analysis
Term Paper

Submitted to,
Prof. T. D. Choudhury

Submitted by:
Shradha Diwan
08 BS 000 3170
ICFAI Business School, Kolkata

shradha.diwan@gmail.com
INTRODUCTION

SENSEX reached a peak of 20,000 and then fell like a pack of cards to 10,000. Do these
numbers suggest anything about the macroeconomic growth of the country?

“The stock market is a casino” – states the Keynesian thesis. However, it is also agonized
that stock markets enable people with money to invest to come together with people who
can put that money into productive use.

The relationship between stock markets and macroeconomic growth has been the subject
of numerous debates. Economists, analysts, and financial policymakers have conducted a
plethora of studies on the subject but nothing substantial has been concluded as yet.

Most market participants talk of economic fundamentals and say that as long as the years
of unsatisfied demand in the country are still there, the growth story will continue.

However, it is also a known fact that stock markets do not react to certain news at all, while
reacting wildly even to some rumors. Surely, all those second-by-second movements
cannot be based on economic fundamentals.

Indeed, the exponential rise of the SENSEX also corresponds to one of the most spectacular
periods of growth in the economy (when the country witnessed a CAGR of 8.6% for three
consecutive years). Most sectors, except agriculture, have witnessed above average growth.

Some analysts became concerned about a price bubble being created in the stock markets.
A financial bubble arises when the market prices are not reflective of the actual reality.
Exuberance in the stock market which is not based on economic fundamentals, but on
support from speculators, is likely to be irrational.

The assignment deals with analyzing the impact of economic fundamentals on the Stock
markets.

For the objective, the macroeconomic factors considered are:

1. Impact of GDP of the country on the stock markets

2. Impact of Foreign Institutional Investors (FIIs) on the Indian Financial Markets,
including the Stock market, and how this hot money turned out to be the country’s
biggest foe in times of financial crisis

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CORRELATION BETWEEN GDP AND SENSEX

The following statistical analyses deal with establishing a relationship between India’s GDP
and the BSE SENSEX and observing if there exist substantial correlation between the two
over a period of 10 years.

Methodology:

1. The statistical correlation between the SENSEX and the GDP (constant prices, base
1999-00) of India is calculated
2. The period of the study is from the first quarter of FY 1999-00 to the last quarter of
FY 2008-09 (10 years)
3. In order to make the SENSEX comparable with quarterly GDP, quarterly averages of
the SENSEX are taken
4. The annual correlations between GDP and SENSEX are also calculated
5. The 4 quarters’ moving averages of the SENSEX and GDP are calculated
6. The regression model between SENSEX and GDP is also obtained (Dependent
variable – Sensex; Independent Variable - GDP)

The following are the observations:

Step 1: Statistical correlation between the SENSEX and the GDP (constant prices, base
1999-00) of India

Period of the Study: Q1 FY 1999-00 to Q4 FY 2008-09

The correlation is 0.840

This is our first linkage. (Refer Annexure A for data)

Correlations

GDP BSE
GDP Pearson Correlation 1 .840**
Sig. (2-tailed) . .000
N 40 40
BSE Pearson Correlation .840** 1
Sig. (2-tailed) .000 .
N 40 40
**. Correlation is signif icant at the 0.01 level
(2-tailed).

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Step 2: 4 quarters’ moving average of SENSEX and GDP

Step3: Annual correlations of GDP and SENSEX

From the following graphs, it

can be observed that GDP and
SENSEX show a high degree of
correlation between the period
2002-03 and 2006-07.
However, if we analyze the data
more deeply, year-on-year
examination gives a different
picture. The outcome of this
examination shows that though
the real GDP as shown a steady
growth over the period of
study, BSE SENSEX has been

very volatile during the entire

period. On year-on-year basis, there
seems to be no sync between the
two factors.

(Refer Annexure B for data)

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Regression Model:
It is observed that the R-square value of the model is .706 with acceptable t-values. The
model establishes the role of fundamentals in terms of quarterly GDP of the country and
the stock market. From the model, we see that the beta of the regression model is 0.840.
such a high positive value of beta indicates strong positive sensitivity between the SENSEX
and the GDP.

Model Sum m ary

Adjusted Std. Error of

Model R R Square R Square the Estimate
1 .840a .706 .698 2583.14988
a. Predictors: (Constant), GDP

ANOVAb

Sum of
Model Squares df Mean Square F Sig.
1 Regression 6.09E+08 1 608810540.1 91.240 .000a
Residual 2.54E+08 38 6672663.286
Total 8.62E+08 39
a. Predictors: (Constant), GDP
b. Dependent Variable: BSE

Coe fficientsa

Unstandardized Standardized
Coef ficients Coef ficients
Model B Std. Error Beta t Sig.
1 (Constant) -9689.309 1849.908 -5.238 .000
GDP 2.847E-02 .003 .840 9.552 .000
a. Dependent Variable: BSE

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The Financial Crisis and India’s Financial Markets:

Despite the vanishing foreign institutional investors (FIIs), the Indian markets remained
resilient and stayed afloat. Investors’ sentiments have been significantly impacted by the
US financial crisis. The tendency of investors to withdraw from risky markets has resulted
in significant capital outflows that have led to a liquidity crunch putting pressure on the
Indian stock market.

The Indian economy continues to show good health because of Decline in RBI’s
the strength of its domestic drivers, like infrastructure projects,
Forex Reserves
SME (small and medium enterprises) sector exports and good
yielding from the agricultural sector. Depreciation of
The cause behind US economy debacle is that the US investment the Rupee
banks are extremely over leveraged and solely dependent on
whole sale finances. This led to their demise. But such is not the Decline in Stock
case with Indian Banks. The common man’s deposits are more Market Indices
in India and they have the trust on the Banks, because all most
all the Banks are nationalized and the depositor’s interest is
highly protected by Government of India.

In the US, the investment banks are dependent on institutional investor’s funds. These
investments are highly volatile and always search for high returns on their deposits. They
look for Demand-based investments and not time-based investments. Therefore, whenever
the returns from one market start dipping, they move their investment to re-invest in those
markets which would offer a better return, or take a defensive stance until the market
regains momentum.

Domestic banking in India is generally secure, especially because nationalized banking

remains at the core of the system. Even so, there exist signs of fragility and inadequacy
within the banking sector. The effects of the global crisis have directly impacted some
important macroeconomic variables. Three such indicators stand out in terms of their
sudden deterioration since the middle of last year:

(i) Decline in the foreign exchange reserves held by the Reserve Bank of India
(ii) Fall in the external value of the rupee, especially vis-à-vis the US dollar
(iii) Decline in the stock market indices

Measures taken by the RBI to stop depreciation of the Rupee led to a steep decline in its
foreign exchange reserves. Factors which also contributed to the decline were the
revaluation in foreign currencies and large scale pullout by foreign institutional investors.

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 Figure 1 shows how the foreign
exchange reserves, which had
been increasing steadily over the
past few years, started declining
after June 2008. Not that the
earlier build-up of reserves
reflected any great
macroeconomic strength, since
unlike China it was not based on
current account surpluses.
Instead, the Indian economy
Figure 1: Foreign Exchange Reserves held by the RBI. experienced an inflow of hot
Source: The Hindu BusinessLine money, especially in the form of
portfolio capital investment of FII.

But that movement of FIIs was in

turn related to the sudden collapse
of the rupee, shown in Figure 2.
Early in March 2009 the rupee even
breached the line of Rs 51 per dollar.
There are those who argue that this
depreciation is positive since it will
help exports, but conditions
prevailing in the world trade
market, with falling export volumes
and values, does not give rise to Figure 2: Rupees per US Dollar; Source: The Hindu BusinessLine
much optimism in that context.

India currently has a current account deficit, including a large trade deficit and also quite
significant factor payments abroad. The falling rupee implies rising factor payments (such
as debt repayment and profit repatriation) in rupee terms, which is not good news for
many companies for the balance of payments.

Associated with all this is the

evidence of falling business
confidence expressed in the stock
market indicators. The Sensex
(Figure 3) had reached
historically high levels in the early
part of 2008, capping an almost
hysterical rise over the previous

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Figure 3: Sensex Daily Movements; Source: The Hindu BusinessLine

three years in which it more than tripled in value. But it has been plummeting since then,
with high volatility around an overall declining trend such that its levels in early March
were below the levels attained in December 2005.

Role of Foreign Investors:

Figure 4 tracks the changes in

total foreign investment, split up
into direct investment and
portfolio investment, over a
period since April 2007. It is
evident that both have shown a
trend of increase followed by
decline. FDI has been more stable
with relatively moderate
fluctuations (even though it does
include some portfolio-type
Figure 4: Foreign Investment; Source: The Hindu BusinessLine investments that get categorized
as FDI). It peaked in February
2008 and thereafter it has been coming down but is still positive.
Portfolio investment has been extremely volatile and largely negative (indicating net
outflows) since the beginning of
2008, and this has dominated the
overall foreign investment trend.

As a result, as is evident from

Figure 5, the cumulative value of
stock of Indian equity held by FIIs
fell quite sharply, by 24% between
May 2008 and February 2009.
This is not likely to be due to any
dramatically changed investor
perceptions of the Indian
economy, since if anything GDP Figure 5: Cumulative FII Investments in Equity; Source: The Hindu
BusinessLine
growth prospects in India remain
somewhat higher than in most other developed or emerging markets. Rather, it is because
portfolio investors have been repatriating capital back to the US and other Northern
markets.

This reflects not so much as a flight to safety (for clearly US securities are not safe anymore
either) as the need to cover losses that have been incurred in sub-prime mortgages and

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other asset markets in the North, and to ensure liquidity for transactions as the credit
crunch began to bite.

Whatever the causes, the impact on the domestic stock market has been sharp and direct.
Since the Indian stock market is still relatively shallow, and FII activities play a
disproportionately sharp role in determining the movement of the indices, it is not
surprising that this flow has been associated with the overall decline in stock market
valuations.

As Figure 6 shows, the Sensex

has moved generally in the same
direction as net FII inflows. In
fact, movements in the latter
have been much sharper and
more volatile, suggesting that
domestic investors have played a
more stabilizing role over this
period.

Figure 6: FIIs and the Stock Market; Source: The Hindu BusinessLine

Overall foreign investment flows

(including both FII and direct
investment) have also played a role
in determining the level of external
reserves. Figure 7 shows the
pattern in aggregate net foreign
investment and change in reserves
since April 2007.

Once again, the two move together.

However, in this case, foreign
investment has been less volatile
than the change in reserves, Figure 7: Foreign Investment and Change in Reserves; Source: The
suggesting that other components Hindu BusinessLine

of the balance of payments have

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been important as well. The changes in external commercial borrowing are likely to be
significant.

In addition, the possibilities of domestic investors moving their funds out should not be
underestimated. The recently liberalized rules for capital outflow by domestic residents
have led to outflows that are not insignificant, even if still relatively small.

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CONCLUSION

If we look at the trend, stock markets are not always guided by fundamentals but also by
sentiments. For instance, lowering of interest rates by the RBI typically has an impact on
the economy with a lag. But the signal that the RBI is reducing interest rates may prop up
stock markets immediately and stock prices may react much faster.

However, in the present period there is a change in the trend, due to the fact that Indian
economy is now more integrated with global world than before. At worldwide level capital
markets evince attributes of perfect market with no or acceptable entry barriers, large
number of buyers and sellers, absence of, or very low, transaction costs, tax parity and free
trading.

To attract international investments, countries compete with each other and promote their
capital markets with savvy sops and policy announcements. No modern economy can exist
without an efficient capital market. This is what has attracted international investors, who
in recent years have made India their favorite destination. Since our markets are now
globally integrated, if we look at recent trends, for instance, when IIP numbers were
positive, still we were unable to lift the markets. However, most of the times we get to hear
that markets are crashing due to weak global cues, or an uncertain event at international
level has had an effect on our markets.

The crux of the issue is that an economy goes through business cycles of recovery, boom,
slowdown and recession. Stock market also moves on similar pattern. For instance if Indian
GDP grows at 10 percent in one year, the SENSEX may not gain similar percentage during
the same year. However, the relationship may hold true over the longer-term. It may be
stated that the state of the economy has a bearing on the share prices but the health of the
stock market in the sense of a rising share price index is not reflective of an improvement
in the health of the economy.

Summing up the basic purpose of all studies done is to find out relations between economic
growth and stock markets. Though it can’t be neglected that stock market directions are
based on fundamentals in the long-term, however, these assumptions may turn out to be
dangerous for investors in short-term. Therefore, most analysts would advice us to go for
investment in stocks with a long-term perspective in mind

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REFERENCES

1. Global Crisis and Indian Finance, C.P.Chandrasekhar and Jayati Ghosh, The Hindu
BusinessLine
2. Global Crisis News, www.globalcrisisnews.com
3. www.rbi.org – Statistics on Indian Economy – Annual Publications
4. BSE India Website – Historical Prices of SENSEX
5. The Reserve Bank of India – Press Releases, Handbook of Statistics; Special Reports
6. Ministry of Communications and Information Technology – Statistics

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 Annexure A

Year GDP (Rs crore) GDP 4 QUARTERS' BSE SENSEX 4 BSE SENSEX 4
MOVING AVERAGE MONTH AVERAGE QUARTERS' MOVING
AVERAGE

99-00 Q1 421795 446631 0 4613.674167

Q2 396646 452011.5 4734.99 4814.294167
Q3 477775 458612.25 4690.863333 4701.175833
Q4 490308 463895.5 5218.013333 4501.8875
00-01 Q1 443317 466075 4613.31 4212.229167
Q2 423049 471139.25 4282.516667 3942.889167
Q3 498908 476705.25 3893.71 3654.4125
Q4 499026 485129.75 4059.38 3475.921667
01-02 Q1 463574 493151.75 3535.95 3322.9675
Q2 445313 499033.75 3128.61 3248.029167
Q3 532606 505007 3179.746667 3229.23
Q4 531114 507211.75 3447.563333 3230.578333
02-03 Q1 487102 512072.75 3236.196667 3167.250833
Q2 469206 518644.75 3053.413333 3170.5075
Q3 541425 529220.75 3185.14 3448.035833
Q4 550558 544526.5 3194.253333 3967.638333
03-04 Q1 513390 555689.75 3249.223333 4581.89
Q2 511510 566345.25 4163.526667 5037.098333
Q3 602648 575470.25 5263.55 5325.050833
Q4 595211 583744 5651.26 5551.600833
04-05 Q1 556012 597096.5 5070.056667 5785.670833
Q2 548010 609527.75 5315.336667 6190.106667
Q3 635743 621468 6169.75 6867.55
Q4 648621 636710.75 6587.54 7498.3675
05-06 Q1 605737 653211.75 6687.8 8482.323333
Q2 595771 667688.75 8025.11 9548.689167
Q3 696714 682674.25 8693.02 10450.52417
Q4 714625 698829 10523.36333 11647.69583
06-07 Q1 663645 716077.25 10953.26333 12358.61417
Q2 655713 731403.25 11632.45 13209.24333
Q3 761333 746721 13481.70667 14314.52167
Q4 783618 763552.5 13367.03667 15901.4425
07-08 Q1 724949 780715.5 14355.78 16799.00583
Q2 716984 795241.25 16053.56333 17140.43417
Q3 828659 809417 19829.39 16608.76917

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 Q4 852270 820608.75 16957.29 14028.7625
08-09 Q1 783052 833272.25 15721.49333 12124.8025
Q2 773687 850012.3333 13926.90333 10925.90556
Q3 873426 888175 9509.363333 9425.406667
Q4 902924 902924 9341.45 9341.45

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 ANNEXURE B

Year Correlation between Sig (two tailed)

GDP and Sensex
99-00 0.543 0.457
00-01 -0.762 0.238
2001-02 0.077 0.923
2002-03 0.497 0.503
2003-04 0.912 0.088
2004-05 0.969 0.031
2005-06 0.84 0.16
2006-07 0.948 0.052
2007-08 0.71 0.29
2008-09 -0.945 0.055

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