This question has been asked by many of my students. I also hear such lines in many discussions over the economy ranging from tea stalls, dinner parties to business school boardrooms – “SENSEX is going down, economy is not good”!, How justified is it in thinking that movements in SENSEX reflects the state of the economy?
To answer this question, we need to put things into perspective. We first need to understand what SENSEX is. SENSEX, in a very simple language is an index representing the movement in the share price of major companies listed in the Bombay Stock Exchange. (The same discussion can be held over NIFTY, which is a similar index for National Stock Exchange).It is one number, that represents the whole share market. The movement of SENSEX tells you if the prices of shares listed on the stock exchange are going up or down as a whole. Now let us see, what is stock market, of which Bombay stock exchange is an example. Stock market is a platform where buyers and sellers of shares meet and carry out their transactions of buying and selling of shares.
Now let us understand who are these buyers and sellers of shares. These buyers and sellers are investors who either are in possession of some shares of any number of companies or are willing or looking to buy shares of companies. An important fact to understand is that all these players are in the market to earn profit and are looking for signals to find the right time to sell and buy. Every one of these players is looking to buy at a low price and sell at a higher price.
Now, what drives the movements of the share price? It is a simple demand and supply mechanism. For this we, first need to understand that Demand for shares is created by Buyers of shares and Supply of shares is created by Sellers of the shares. Therefore Demand of shares will go up/down if number of Buyers increase/decrease. Similarly, Supply of shares will go up/down if number of Sellers increase/decrease.
Like any good, price of a share will go up if:
- Demand of share goes up, supply remaining same (No. of Buyers > No. of Sellers)
- Supply of share goes down, Demand remaining same (No. of Buyers> No. of Sellers)
Similarly, price of a share will go down if:
- Demand of shares goes down, supply remaining same (No. of Buyers < No. of Sellers)
- Supply of shares goes up, Demand remaining same (No. of Buyers < No. of Sellers)
Having got this concept clear, let us now understand what will cause the number of buyers and sellers to go up or down. For that let us understand what they have in their hand: SHARE. Now, what is a share? Simply speaking, a share of a company is an instrument of ownership of shareholding in the company. So if I buy Rs 5,000 worth of share in a company, whose share price is Rs. 100, I become an owner of 50 shares in that company, to the value of Rs. 5,000. I will earn profit if I am able to sell that share at any price above my investment i.e at any price above Rs 50. And of course, I will bear a loss if I sell the share at any price below my investment i.e at any price below Rs. 50.
Now the behaviour of these buyers and sellers in the market basically reflects their opinion on future of the company’s share that they are holding. So they act on what is very popularly known as “market sentiments”. These market sentiments are nothing but “feelings” of buyers and sellers on whether price of shares will go up or down in the future. These sentiments are created by various news that can have an impact on the fortunes of the company in question. These news can be any news that can affect the performance of the company whose shares are bought and sold.
Now we need to understand, what are these news that shape the market sentiment. These news can be divided into three types:
COMPANY NEWS: These are developments related to the company that reflect/affect the performance of the company. Simply said, these are internal factors that affect company performance. This can be company’s results (Annual or Quarterly), Legal proceedings, Signing of a new deal, Merger and Acquisition etc. e.g. if the company’s financial results are good and surpass the expectation of the market, the price is likely to go up.
INDUSTRY NEWS: These developments are related to the industry of which the company is a part of. An example can be government announcements relating to the industry. E.g. the government announces the raising the FDI limit in retail sector. This news is positive for the industry as more foreign investment is going to come into the sector so the share prices of all the retail companies in general are expected to move up.
ECONOMY NEWS: These developments are related to the economy wherein announcements of important macro-economic indicators like GDP growth, Inflation, Fiscal Deficit, Foreign exchange stability, Industrial Output etc. affect the expectations of future performances of the companies. Let’s say RBI increases interest rates because of rising inflation. This increases the borrowing cost of companies which is expected to add to their cost of production and bring down their profits. This will bring down share prices of most of the companies in the market. Nowadays, Indian stock markets are affected by not only the macroeconomic indicators of Indian Economy but also those of the global economy. E.g Of late, debt crisis in the eurozone has been adversely impacting the share prices in the Indian stock markets. This is because companies nowadays are impacted by developments all across the world as due to globalisation, their business interests are spread globally.
Now having understood the dynamics of share market and what drives the prices of shares in these markets, let us come back to our original question. Can SENSEX be quoted as an important barometer of the Indian Economy.
The answer to this question is: While SENSEX (for that matter any index reflecting stock market performance) is a good indicator of the performance of the economy, it can never be, or at least should never be taken as a barometer of the Indian economy. It is important to understand that movement in share prices always reflect “market sentiments” of investors. It is what the investors think that is reflected in the share price movements. In a way that is an opinion of the market on the expectations about the future performance of companies listed on the stock exchange. Movements in share prices can always indicate economic health, but never measure it. Measurement of health of an economy should always be left to key economic indicators and not share price movements that reflect sentiment. So, if you are an investor, you should follow key macro-economic indicators (among other two factors i.e. company news and industry news) that will tend to give you the directions that the markets are likely to take in the future. If you are studying the health of the economy as a student/analyst, then again taking SENSEX as a measure will be ill-advised, taking it as indicator will be preferable.
So, the next debate you join regarding the state of the economy, never quote SENSEX as the barometer of economic health but as an indicator!

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