If you had invested all your savings in the stock market at the end of March last year, by now, you would have almost doubled your money. But in the same period, India's GDP in today's prices would have slid by at least 9-10 percent. Anyone who looks at this divergence will say that the markets have completely 'decoupled' from the economy.
Conventional wisdom tells us that this is a sign of a massive bubble building up and it is bound to burst at some point. After all, if the economy shrinks, so will demand. And if there's no demand, companies will not be able to sell goods or services. Prices will slide and revenues drop. Companies will have to sell their stocks at discounts and, in the process, end up losing money.
That is a bright red flag for stock market investors. In fact, every market guru will tell you that you should invest in businesses that are likely to expand and make good profits in the future. So a recession should make investors take their money out, instead of flooding it into the bourses. So why has the exact opposite happened? Are investors really so naïve or reckless?
To understand the reason, we need to move away from textbook Economics 101 to a more heterodox view of how modern economies work. Think of a simplified economy where everything is produced in factories. Whatever is earned is split between those who own these factories and those who are paid to work in them. Let's assume that in Year One, the economy generated Rs 100 in income. Out of this Rs 60 went to business-owners and the remaining Rs 40 to their employees. In other words, profits made up 60 percent of national income, and wages accounted for 40 percent.
Now imagine that in Year Two, the economy grew by 10 percent to Rs 110. However, the share of profits slipped to Rs 50, while the share of wages rose to Rs 60. Something odd has happened here: GDP increased, but corporate profits reduced. Let's assume that in Year Three, the reverse happened. The economy shrank by 9 percent back to Rs 100. This time, however, profits rose to Rs 70 and wages dropped to Rs 30. So, even though the economy shrunk, profits rose by 40 percent, from Rs 50 to Rs 70.
If one ignored what was happening to the overall economy and only concentrated on profits, then an investor would have every reason to buy more shares. That is because what drives share prices in the medium-term is profits. Markets don't really care about how much employees are paid. In fact, share prices often go up when companies announce that they have reduced their wage-bill. So, it is not the overall economy that matters to stock market investors, but the way national income is distributed.
That is one big reason why stock markets across the world have risen in the midst of the global recession caused by the Coronavirus pandemic. Yes, the recession caused a drop in overall sales of the corporate world, because demand collapsed. Despite that, the returns to owners of businesses have increased sharply while real wages have dropped.
We get a clear indication of this from the earnings data of over 4,300 companies compiled by Centre for Monitoring Indian Economy (CMIE). Between March and September 2020, the total income of these listed companies reduced by 9 percent, more or less tracking the drop in India's nominal GDP. However, their net profit shot up by 746 percent, even though the number of companies covered dropped marginally. During the same period, the total wage bill rose by just 2 percent. In the same period, consumer prices went up by more than 5 percent. So, real profits, adjusted for inflation, increased by more than 740 percent, while real wages shrunk by more than 3 percent.
The stock markets acted in a very rational manner by rewarding companies for tightening their belts and increasing their bottom lines (basically, through cost-cutting), even when their overall sales had reduced. It is corporate profits that decoupled from the economy, not the markets. Of course, the market boom was also helped by the RBI's easy money policy. There was enough money in the system for people to borrow and invest in stocks and shares.
There is one more reason why stock prices rise when owners of capital earn more in the middle of a slowdown or recession. If the demand for goods and services collapses, corporates have no reason to invest more in their businesses. So, they return a part of their retained profits to shareholders by giving them higher dividends or through share buy-backs. High dividends make shares more attractive and increase their demand, pushing up share prices. Similarly share buy-backs also reduce the supply of shares in the market, and cause stock prices to go up.
Since the extra cash being generated from higher profits is not being invested back in the business, it can either be put into term deposits in banks and other debt instruments, or it can be invested in the stock markets. But easy money means low interest rates, and low returns from bank deposits. If this comes in the middle of high inflation, then it's a double whammy. Right now, a term deposit in any Indian bank fetches about 5-6 percent interest, whereas retail inflation in the December quarter was 6.4 percent. In other words, real interest rates are negative.
The only place which gives positive real returns is the stock market. So, money saved by the affluent is bound to be invested in stocks and shares. This is a completely rational and the expected outcome of the divergence between economic growth and distribution of national income. If the rich get richer, and inequality increases, overall demand will fall and that will suppress GDP growth. At the same time, asset prices will increase, because the rich have nowhere to park their savings.
Of course, this is bound to implode in the long run. The first signs of cracks can be seen in the government's tax projections for the last quarter of this fiscal. Tax collections had grown smartly in the third quarter - October to December 2020 - compared to the same period in the previous year. Usually, tax collections increase by 30 percent between Q3 and Q4 of any fiscal year. This year's budget suggests it will collapse. Is this a sign of a sharp drop in corporate earnings in the first three months of 2021? If that happens, then the markets might return to their mean.
(Aunindyo Chakravarty was Senior Managing Editor of NDTV's Hindi and Business news channels.)
Disclaimer: The opinions expressed within this article are the personal opinions of the author. The facts and opinions appearing in the article do not reflect the views of NDTV and NDTV does not assume any responsibility or liability for the same.