How important is the stock market as a driver of investment in the economy? The received wisdom has been that corporate managers are rational people who decide to expand capacity or invest when the net present values from new projects are positive. But, is that really true? Don’t waves of optimism or pessimism have an impact on capital expenditure? Lord Keynes certainly thought so and said: “Most, probably, of our decisions to do something positive, the full consequences of which will be drawn out over many days to come, can only be taken as the result of animal spirits—a spontaneous urge to action rather than inaction, and not as the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities.” The inference seems to be that animal spirits aren’t really rational.
A recent paper by Salman Arif of Indiana University and Charles M.C. Lee of Stanford University, titled Does Aggregate Investment Reflect Investor Sentiment?, finds that corporate investment mirrored waves of optimism and pessimism among investors in 13 of the 14 developed economies they studied. Interestingly, they also found that “higher levels of corporate investment also precede lower corporate profitability, greater earnings disappointments, lower short-window earnings announcement returns, and lower macroeconomic growth”. Moreover, high levels of corporate investment are followed by lower stock returns, particularly for growth stocks.
This seems strange because surely capital spending takes place when businessmen believe it will pay in the future? In other words, the implication is that corporate managers frequently make errors in investment decisions because they are swept along by the ups and downs in the stock markets. The researchers found that corporate managers make more investments when analysts are forecasting higher one-year ahead earnings, although earnings generally fail to live up to those high expectations. The result is lower stock returns after an investment binge. Further, many periods of high investment in the US were followed by recessions.
Looked at in another way, the results explain the business cycle. Businessmen get carried away when the economy and markets are doing well and the upshot is over-investment, which pulls down profits and leads to a downturn. The downturn is exacerbated by pessimism until the cycle turns again.
In India, both Prime Minister Manmohan Singh and finance minister P. Chidambaram realize the importance of animal spirits in spurring investment. The first thing Singh did after Pranab Mukherjee left the finance ministry was to talk of the need for reviving animal spirits in the economy. Chidambaram’s roadshows and his attempts to push reforms, give the government’s image a makeover, and trying to talk the markets up are also attempts to infuse optimism.
He is not alone. US Federal Reserve chief Ben Bernanke’s entire monetary policy is aimed at improving sentiment in the stock markets, which is expected to, via the so-called wealth effect, increase consumer spending, which, in turn, will lift investment. In a recent interview with CNBC, Alan Greenspan, ex-maestro of the US Federal Reserve, said, “data shows that not only are the stock markets a leading indicator of economic activity, they are a major cause of it.”
Do Arif and Lee’s results hold in India? Economists will have to come out with a research paper on the subject, but it’s true that over-investment in the mid-nineties did result in a slump and a long period of stagnation in the stock markets. CMIE (Centre for Monitoring Indian Economy) data show the percentage change in gross fixed assets of the non-financial corporate sector peaked in 2008-09 and the market is still below the highs reached in early 2008. Gross domestic product, or GDP, growth is well below its 2006-07 peak.
Arif and Lee’s paper also says net inflows into the equity markets is the single-most important explanatory variable for changes in aggregate investment. The inflows lead to higher price-earnings multiples and investor optimism results in lots of money being raised from the markets. Bankers turn optimistic and it becomes easier to borrow. All this lowers the hurdle rate for new projects. This is precisely what happened in India during the last boom. Sentiment or animal spirits may be nothing but the weight of money.
If investment mirrors sentiment, shouldn’t a rise in the stock markets lead to a rise in investment demand in India, too? It’s true that a rise in the stock markets will allow more firms to raise capital and this will help repair balance sheets. At the same time, it has to be realized that India is different from the developed countries, because the Indian economy faces supply, rather than demand, constraints and the slowdown it’s in is partly structural. The bottlenecks in power, coal, land acquisition, gas, iron ore, the huge fiscal deficit, the wastage of food procurement and the lack of productivity in small-scale manufacturing and agriculture will not go away by lowering the cost of capital.
The market knows that well, which is why the BSE Capital Goods index has a price-earnings multiple of half the FMCG index. The capital goods index is down 10.8% from a year ago, while the FMCG index is up 40.4%, mirroring the respective strengths of investment and consumption demand.
Manas Chakravarty looks at trends and issues in the financial markets. Your comments are welcome at