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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 optimismwherein good news or adverse shocks get factored. The India shining story is often linkedwith the reflection seen in these numbers. At the same time, sceptics hold that the marketis sentimentdriven and hence, at times, even good news on the economy front can beoverwhelmed by random events. The market buzz on hiking of interest rates could lead toa decline in the market when economic conditions are otherwise sanguine. What really isthe 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 abearing. The variables that can affect the market mood are growth in credit, industrialgrowth, capital issues, inflation, FII investments, exchange rate movements, changes inforex reserves and mutual funds investments. The period chosen is from April 2006 toSeptember 2010 and data has been reckoned on a monthly basis. This takes care of theday to day aberrations in the stock market movements. It has been noticed that even on adaily basis news affects the Sensex only momentarily which is generally mean revertingby the end of the day.

The multivariate regression model gives some interesting results. The first is thatgrowth in credit, industrial production, exchange rate and changes in forex reserves donot 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 alsonegative for the exchange rate suggesting that a falling rupee pushes down the marketmood. Usually one would associate credit growth to mirror industrial buoyancy, but whenit comes to the market, it doesnt really matter.

How about the significant variables? The other four variables are significant. Higherinflation actually pushes back the Sensex and goes with a negative sign, which makessense. 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 wouldexpect as the two are expected to move in consonance as IPOs become more visible whenthe 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 to0.003% increase in the Sensex or $1 billion implies 3% increase in the same. The impactof mutual funds is more muted with the coefficient being 0.00097. While these numbersby themselves are not sacrosanct, the major takeaway is that these four variables explain48% of the variation in the Sensex, also called the coefficient of determination. Whatdoes this mean? This implies that roughly half of the variation in the stock indices isdriven by economic factors, while the rest is guided by sentiments that cannot really beexplained. Therefore, when we talk of market sentiment which is positive or negative, it

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is really a collection of different trading thoughts that are not amenable to statisticalcalculation. The implication is significant as it also means that we should not get swayedby 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 ofexuberance albeit irrational, when things move downwards.

The other important metric that can be examined within the world of econometrics iscausation. While FIIs and mutual funds appear to be drivers of the market in statisticalterms, is it possible to say that they cause the Sensex to move? The Granger Causalitytests carried out do not show a relation either ways FIIs or mutual funds causing theSensex to move or the Sensex causing these flows to expand or contract. What all thismeans is that the stock market movements will remain an enigma for the statisticallyminded investor where economic fundamentals explain part of the story, while the restwill remain the proverbial mystery.