ECONOMY, MARKETS AND EARNINGS - The unbreakable relationship

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  ECONOMY, MARKETS AND EARNINGS - The unbreakable relationship


           

The stock market is the word of the hour. Everyone wants to make a lot of money via investing. People are on the constant lookout for a multibaggers that would turn around their lives. The Indian markets are booming, and everyone is looking for an opportunity to wash their hands in the flowing water. While this is great, one has to understand why our markets are booming. At the end of the day, the relationship between markets, the economy, and earnings is what describes the path of the markets and your portfolio. Markets are a reflection of earnings as well as the state of the economy. As for the relationship between markets and earnings, as said earlier, markets and earnings are positively correlated. Meaning, if Indian companies report poor or negative earnings, then the markets are supposed to fall. This phenomenon takes place because we value companies based on their earnings. To simplify the statement, investors will invest in a company only if they are able to predict the company's earnings in the years to come and not the share price. For example, the reason why we are experiencing buying in energy stocks is that investors are betting that these companies are going to earn a lot of money in the future as India is transitioning from a crude-driven economy to a greener economy and hence the share price would rise. Investors are betting on future earnings and not current earnings. Another example would be Amazon. Back in the 90’s, Mr. Bezos understood the importance of the internet and what kind of disruption the product was about to deliver, followed by the earnings, and hence he bet everything he had on one project, and look where he is today. If investors believe that India will need at least a decade to implement this transition, we may see a sell-off in energy stocks. But the principle remains the same, which is that earnings and markets go hand in hand. Speaking about the economy, positive economies would unquestionably have positive markets as companies would enjoy record earnings and new businesses would open up, followed by a lot of fundraising. Vice-versa, stagnant or falling or even negative economies would have negative markets as companies would be in the doldrums. It’s just like an ordinary human. Our performance tends to fluctuate according to our environment. Speaking about the health of the economy, we use various economic indicators to judge its health. For example, companies would go on a capital expenditure cycle because the demand for that particular good is increasing. For example, auto companies in India are experiencing one of the biggest capex cycles experienced by this nation as demand for cars as well as 2-wheelers is strong. Companies like Maruti Suzuki went out and opened 2 new manufacturing plants in Gujarat, which had a cost of around Rs 10500 Cr. followed by Tata Motors, which bought Ford’s plant to increase its manufacturing capacity. The company spent more than Rs 3000 Cr on various other projects. India has 2 economic indicators which track these changes and adjust themselves accordingly. The indicators are the PMI, or purchasing managers' index, and the IIP, which stands for Index for Industrial production. The PMI has a benchmark of 50. PMI above 50 means the economy is flourishing as production is increasing as demand is resilient and a data below 50 means that the country is facing a slowdown.  Germany is going through this same situation, and hence, German markets are down by more than 20%. German investors are worried about the future earnings of companies listed in the DAX (German Index) and, hence, they are valuing companies accordingly. In all, what I want to convey is that the markets will perform in parallel to what is happening in the economy. They have to adjust according to the country’s economic health and earnings reported by their companies. As I pen down this article, i.e., 30th Aug, and as it happens to be MR Buffet’s birthday, I would like to quote one of his famous statements, which goes by, "Markets can stay irrational longer than you can stay solvent."

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