Does the stock market reflect state of the economy?

The stock exchange in any country is comprised of leading companies which play a pivotal role in the respective economy. 

Accordingly, stock market is so sensitive that it quickly responds to changes in economy, being vulnerable to internal as well as external shocks. What never happens is that the stock market reflects something totally against the state of the economy, since it is not only a cog of the wheel of the economy but also a barometer of economic performance. 

When it comes to Colombo Stock Exchange (CSE), its performance too should be reflected by present and future economic prospects in the country. Here, it is expected with this article to ascertain the correlation between stock exchange and economically-important incidents taking place in the country, since investor sentiments could also be negatively impacted by possible economic downturns. 

Even if the stock market indices went up sharply soon after war ended exactly nine years ago, the story has changed considerably at present, diverting investors’ attention elsewhere. Hence, the market has put itself on a slower path. Here is why.

Instability 
When something is instable or fluctuating, decisions cannot be made. The same is applied to the stock market as well. However, it has to be accepted that country is politically unstable, given the facts that the present government went for a cabinet reshuffle for the fourth time, other sixteen ministers left the government, especially election results at recently held local government election and many more. Furthermore, when economic and political policies change at higher frequency, it is needless to say that business community and investors are at a loss to make decisions. Even Central Bank governor Dr. Indrajith Coomaraswamy emphasized on the importance of political stability few months ago, so that investor confidence would be boosted.  This can be considered a reason for poor performance which currently can be seen at the stock market. 

Contraction 
It is an economically-tough time for the country, as disposable income has contracted significantly, due to changes like increase of taxes, fuel price hike and low prices for crops directly impacting on personal income. Even though direct taxes can make sure equality in government’s perspective, it is not so good for fixed income earners. 

Furthermore, when people’s purchasing power goes down, they tend to spend on essentials only, ultimately reducing sales of companies and then profit. A company with low reserves cannot go for investments which actually create new employment opportunities. This is a very simple formula which anyone can grasp. 

The problem that needs to be highlighted here is that this kind of unfavorable business environment where consumers are badly affected will not attract investors. One can pose a challenge as to how the Colombo Stock Exchange attracted highest ever foreign inflows last year. It was due to favorable P/E ratio which currently remains at the 10-11 times that foreign equity investors paid their attention to the CSE. 

Economic growth slumped to a 16-year low in 2017 with agricultural sector slowing down, mainly due to natural disasters. However, Gross Domestic Production (GDP) grew by 3.1 percent in 2017. It means that the amount of goods and services produced in the economy had fallen, while the value of those goods and services went up comparatively. When it comes to tea exports, quantity decreased, but prices received increased. Anyway, this is also reflected in the stock market.  

Natural disasters 
The frequency at which Sri Lanka has had to face natural disasters has gone up like never before, destroying human resources, infrastructure facilities and crops which damage the economy in the end. It could be observed that how insurance companies’ stocks were hit during the period of severe flood, as their money flowed out of the company as compensations, especially for vehicles damaged by the flood. 

The plantation sector and tourism industry are also victims of this kind of severe disasters. Natural disasters are out of control. Its impact goes from bad to worse, when people without any kind of insurance coverage get affected, making them economically bankrupt. They take a long time to recover in a country like ours, as ways to support them are in a poor state. 

Weak policies 
Everything needs strong and clear policies to be successful. Similarly, Stock Exchange also needs certain proposals to be implemented. Even if it was proposed in the budget last year that two leading state banks; Bank of Ceylon and People’s Bank would be listed in the stock market, it couldn’t be put into practice thus far. 

Retail investors don’t seem to be so interested in trading, due to lack of clear policies. Furthermore, it has to be noted that any kind of development activity that started for past few years cannot be seen. Economy can be said to be at a standstill with huge debt burden. 

Reality
Stocks of well-performing companies can be discounted, because of poor performance of the overall market. When we check, we can see how stock prices of certain companies that posted a significant increase of profits have gone down, having been affected by unfavorable macroeconomic environment. 

For rational investors, this is a great opportunity where valued stocks can be bought at discounted prices. Stock market clearly reflects state of the economy. What should be kept in mind is that an economy may change. So, invest in stocks based on your forecast. 
Amila Muthukutti 
(Amila Muthukutti is an economist)