There’s Nothing ‘Irrational’ About India’s Sensex Highs — It’s All Profits

The idea that the markets are displaying an ‘irrational exuberance’ is based on a flawed understanding.

How is it possible for Sensex to hit new highs when India’s economy has still not recovered to where it was three years ago? Mainstream economists will tell you that this is a sign that the financial markets have decoupled from the real economy. They’ll say that a dangerous bubble is building up in the system that is bound to burst sooner than later.

This idea that the markets are displaying an ‘irrational exuberance’ is based on a fundamentally flawed understanding of not only how the stock markets work, but also how they are related to the economy as a whole.

To understand this, we have to leave the world of mainstream economics and enter the domain of political economy.

Modern capitalist economies (for the sake of simplicity we will treat India as one) are made up of three groups of people. The first are those who own productive resources such as land, factories, machines and offices. The second, much larger group is made of those who work for the first group. And the third are those who facilitate this system and ensure that it runs smoothly. These not only include the supervisors and managers who run businesses on behalf of owners of capital, but also netas (politicians), babus, judicial officers, cops, lawyers, teachers, and everyone else essential for reproducing the rule of capital.

Markets Chase Profits

But one can also be an owner of capital, albeit just an aliquot part of it, by owning shares of companies. That’s because shareholders in a company’s stock have rights over its profits. So, the stock markets as a whole move up or down depending on the share of profits in the overall income generated in an economy. If that share rises, markets go up. If it falls, then the markets either fall or move ‘sideways’.

Let’s take a hypothetical example to explain this. Imagine that the total income generated in an economy is ₹100 in Year One. Out of this, ₹50 goes to those who owned capital in the form of profits, and the remaining ₹50 to those who work for them, in the form of wages and salaries. In Year Two, the economy expands to ₹110. This time, however, the share of profits drops to ₹45 and the share of wages increases to ₹65. The stock markets would drop even though the country’s GDP has grown by 10 per cent.

Now, imagine that there is a recession in Year Three and the size of the economy shrinks to ₹95. This time, wages drop sharply to ₹40, but profits rise to ₹55. Even though the country’s GDP dropped by 13.6 per cent, profits rose handsomely by 22 per cent. Stock markets would now rise to reflect the rise in profits. In other words, the higher the inequality between capitalists and their employees, the better the stock markets would do.

What if in Year Four, the GDP bounces back to ₹115, profits rise to ₹58 and wages rise to ₹57? Ideally, the markets should rise because profits have grown and the rise in wages should stimulate demand and boost future profits. Yet, chances are that the markets would contract, or at best rise gradually. This is because capitalism bets on the accumulation of productive resources. In this case, even though profits have grown, the share of profits viz-a-vis wages has dropped. This is a problem for the functioning and reproduction of capitalism as a system.

In a nutshell, markets chase profits. If the share of profits rises, then whether an economy is growing or contracting, the stock markets rise as well.

Net Profits Shot Up

This is exactly what is happening in India right now. The latest complete data that we have of quarterly GDP and corporate earnings are for the quarter ending June 2021. However, since quarterly numbers tend to fluctuate a lot and have seasonal variations, I am going to aggregate the numbers for four consecutive quarters, to compare 12-month periods between July to June. I will compare the GDP and BSE100 earnings data for July 2019 to June 2020 with those of July 2020 to June 2021. And since earnings data are reported at market prices that prevail at that point of time, I will compare them to ‘nominal’ GDP numbers at current market prices.

Between these two periods that I mentioned above, India’s nominal GDP rose by 9%. At the same time, net sales of the BSE100 companies rose by 6%, more or less tracking GDP growth.

In the same period, wages and salaries rose by just 3%, way below the 6% rise in retail inflation. What happened to the net profits of these BSE100 companies? They went up by a massive 85%.

The rise in profits is even more startling if one compares the numbers for the pre-COVID-19 quarter ending March 2020 with the June quarter of 2021.

While nominal GDP contracted by 2% in this period, the net profits of BSE100 companies rose by a whopping 159%. Salaries and wages in the same period grew by just 5%.

Compare that to the 91% increase in the BSE100 index between 31 March 2020 and 30 June 2021, and you will see that the markets have been reasonably rational in tracking corporate profit growth.

But Who Has the Last Laugh?

This shows that there is no irrational exuberance in the markets right now. The stock markets are accurately reflecting the rise in the returns to owners of capital. And since the markets are forward-looking, they are betting on a faster pace of capital accumulation.

Of course, there are various worrying metrics for stock market watchers. One such metric, called the market-cap-to-GDP ratio, is at an all-time high, even above the 2007-08 period right before the 2008 global financial crisis. And these indicate that there could well be a ‘correction’ over the next few months. But as long as India’s political economy facilitates higher returns to owners of capital and as long as economic policy is decided under the shadow of international finance capital, India’s stock market investors will always have the last laugh.

(The author was Senior Managing Editor, NDTV India & NDTV Profit. He now runs the independent YouTube channel ‘Desi Democracy’. He tweets @AunindyoC. This is an opinion piece. The views expressed above are the author’s own. The Quint neither endorses nor is responsible for them.)