On a new high

The stock market is making history. This is good news for India. A higher stock market is one of the most important indicators of confidence in the economy. It encourages investment. The depths to which the stock market fell at this time last year, made a lot of people think that things are bad and are going to be bad. There was gloom and doom in the market. The performance of the stock market this year seems to have proved them wrong. But, even as this is said, there is need for caution and wisdom.

It is often erroneously believed that the stock market index reflects expectations about the future. But this is not a correct interpretation. Stock prices can also grow because profits go up. It is important to make a clear distinction between stock prices and the price-earnings ratio P/E, the ratio of market capitalisation to net profits. To learn about the optimism of the stock market, or the expectations about future economic growth, we need to look at the P/E ratio. The P/E ratio can be computed at the level of a company, an industry, or the overall stock market index. The P/E of the market index reflects growth prospects of a range of companies, across many different industries 8212; including oil, banking, software, consumer goods, automobiles, steel, and so on. The P/E of the index, therefore, reflects what the stock market thinks about future macroeconomic growth prospects for India. While the Nifty has indeed recovered more than 50 per cent after the crash in May and June 2004, the bulk of this increase has just come from higher profits of companies. The P/E of the index, which reflects confidence and optimism about the future, is roughly as gloomy about the future as it was in June last year, at between 13 and 14. If optimism was as high as it was in January 2004, the P/E of Nifty would have been 21, instead of 14, and Nifty would be at 3000 instead of 2000. The rise in the market index has been slower than the rise in profits.

The current level of the stock market should, therefore, not lead to complacency. The market8217;s subdued optimism should signal to the government the need to strengthen its reform agenda. For a few months after the installation of the reformist team of Manmohan Singh, P. Chidambaram and Montek Ahluwalia in government, the P/E of the stock market index had indeed risen. But optimism soon faded. The government needs to put confidence back into the market in order to encourage investment and growth. It is only good economic policy that would lead to greater confidence, increased investment and higher growth.