Back What is driving the stock indices up
G. Ramachandran
| What is driving the Sensex to new highs? It is the contraction of risks in the Indian economy. Investors in equity foresee fewer and lower risks. Therefore, they are satisfied with a lower desired return in this foreseeable future, and are willing to pay more for equity shares in the present, says G. Ramachandran, explaining the phenomenon. |
Driven as much by risk perceptions as by economic growth: Indicator at Churchgate station, Mumbai, displaying the Sensex crossing the 8000 mark. — Paul Noronha
The S&P CNX Nifty has risen as smartly but it is difficult to overlook the near-total dominance of the Sensex over the S&P CNX Nifty among users in the domestic marketplace. It is also disseminated and analysed by the international business media.
Comparisons with the past performance of the Sensex show that the rise since May is different. It has been particularly steady. Intra-day and intra-week measures of volatility are low. Sensex rose by 2,000 points from about 4,800 in July 2004 to over 6,800 in March 2005. The rise took longer and was significantly choppy.
This article suggests that investors in Indian equity shares perceive fewer and lower risks in the foreseeable future. Therefore, they are satisfied with a lower desired return in this foreseeable future. Since they are satisfied with a lower return in the future, they are willing to pay more for equity shares in the present. The Sensex rise to over 8,000 is driven by a contraction of risks in the Indian economy.
Negative serial correlation
It is not surprising that the rise of Sensex since May 2005 has attracted considerable but dissimilar commentary. The heterogeneity is inevitable as the marketplace comprises different constituents.
Equity analysts, investors and intermediaries constitute the first group. Government, managers of stock exchanges and regulators constitute the second. Economists and empirical researchers in financial markets constitute the third.
The three groups are unlikely to see the rise through the same lens. Moreover, constituents within each group are likely to hold different views. But empirical researchers in financial markets are probably the most detached among the constituents.
Their views and models of equity prices are unlikely to be driven by their own occupational responsibilities, investments, equity research reports and ideological stances on how the economy should be managed.
Professors Ray Ball and S. P. Kothari suggested a model of equity returns and prices in the mid-1980s. They are both empirical researchers and have been cited extensively by other academic researchers. Prof Ball teaches at the University of Rochester, and Prof Kothari at the Massachusetts Institute of Technology.
Their model is based on negative serial correlation. Serial correlation measures the strength of the relationship between observed equity return, say, in August and the expected equity return in September.
If investors want a high return in September, they will necessarily impose on themselves a low return for their investments in August. If investors are happy with a low return in September, they will reward themselves with a high return in August.
The high-low and low-high pairs explain why the serial correlation is negative. Their model provides a reasonable explanation of the smart rise in the index since May. What is more, it explains the precipitous fall of Indian stocks on May 17, 2004.
Prices link returns
The evaluation of investment opportunities involves the estimation of the magnitude of cash inflows and of their riskiness.
To make matters simple let us assume that investment opportunities come in two risk classes A and B, where A is low risk and B is high risk.
The pricing of investment opportunities will reckon with the magnitude and riskiness of cash inflows. First, consider two investment opportunities that belong to the same risk class.
The secondary market price in September of an equity share that offers the bigger cash inflow (Rs 200 on October 1, 2005) will be more than the price of the equity share that offers the smaller cash inflow (Rs 150 on October 1).
Had both equity shares been bought in August for Rs 100, the first equity share will trade in September at a higher price than the second. The higher price will result in a higher return to those investors who invested in the first equity share in August and sell in September.
Second, consider two investment opportunities that belong to two risk classes A and B. They offer the same cash inflows of Rs 175 on October 1. The secondary market price in September of an equity share that has the lower risk — A — will be more than the price of the equity share that has the higher risk — B.
If both equity shares were bought in August for Rs 100, the first equity share will trade in September at a higher price than the second. The higher price will result in a higher return to those investors that invested in the first equity share in August and sell in September.
Past can mislead
What is common to the two examples given above is that the benefits of the higher return accrue to those who sell in September.
The benefits will be paper profits or unrealised returns to those who hold through September.
What is also common to the two examples given above is that the benefits of the higher return may not accrue at all to those who buy in September.
Moreover, the paper profits and the unrealised returns may disappear in the hands of those investors who hold through September until October 1. Cash inflows in October and their riskiness will determine these.
Driven by risk
The pertinent question is if the Sensex rise to over 8,000 in September since May is the result of higher expected cash inflows or a contraction of risk. The answer is risks have contracted in the Indian economy.
Higher expected corporate cash flow productivity fuelled the slow and steady rise of Sensex to 5,000 in November 2003 after it had slumped in March 2001. In this period, net sales to capital employed increased.
Earnings before interest and taxes rose. India Inc. ploughed back a large part of its earnings into capital assets (see Business Line, January 2, 2004). Then came the crash of May 17, 2004. It would be ludicrous to suggest that expectations of cash flows can change so adversely and so rapidly as to pull Sensex down by over 500 points in one day.
It would be as ludicrous to suggest that expectations of cash flows changed favourably since July 2004 to push Sensex to over 6,800 in March 2005. Corporate cash flow productivity and the ploughing back into corporate assets are long-term and gradual processes. They do not go through flip-flops in a hurry. But perceptions of risks can undergo flip-flops at the speed of light.
Contraction of risk
Perceptions of risk pertinent to policymaking, in general, have changed favourably since that horrible day last May.
In particular, perceptions of risk pertinent to trade, capital flows, interest rates and the management of the parity value of the rupee against other currencies have changed favourably since this May. The UPA Government has worked assiduously towards changing the risk perceptions.
The contraction of risk has driven the index up by 35 per cent when the economy grew by less than 8 per cent. Therefore, it is not surprising that Prof Alok Ray has asserted that rapidly rising prices of existing stocks are neither necessary nor sufficient for economic growth (see Business Line, August 24, 2005).
What this means is that the index can tumble by over 35 per cent if risks are expected to rise adversely though the economy is expected to grow by over 8 per cent.
(The author is a financial analyst. Feedback may be sent to indiagrow@yahoo.com and pari@thehindu.co.in)
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