Are Indices true indicators of market condition?

A stock market index measures a section of the stock market, in order to act as an indicator of the market, showing whether the majority of the stocks traded in that market are going up or down, thereby also indicating the overall mood of the investors. The SENSEX and Nifty are such indices.

The BSE Index- SENSEX or the Bombay Stock Exchange Sensitive Index is India’s first stock market index. Launched in 1986, it is an index of 30 stocks representing 12 major sectors and is tracked worldwide, enjoying an iconic stature. The SENSEX is constructed on a “free-float” methodology, and is sensitive to market conditions. It is a broad-base index as it represents the performance of the entire stock market, and therefore reflects investor and market perceptions and realities.

What does this all mean? Simple, that the SENSEX indicates or shows whether most of the stocks being traded in the Bombay Stock Exchange are generally going up or down.

Like the SENSEX, the National Stock Exchange (NSE)’s Nifty is a well diversified 50 stock index accounting for 23 sectors of the economy and depict the investor and trader sentiments in NSE.

It is evident clearly from the above information that the indices SENSEX and Nifty should be apt indicators of the market condition. But is this true? Can a theory or a fact stated be accepted without being challenged or disputed?

The Stock Market Indices serve varied purposes starting from economic research to helping investors decide upon an appropriate portfolio for their investments. As said earlier, since the Index is an indicator of the overall mood of the investors in the secondary market, it also helps a company answer questions like is it the right time to take out an IPO, how to price the issue, etc. It acts as a signal to the government of the ‘feel good’ factor prevailing in the economy. It reacts to all important news and events happening in the country. It also reacts to introduction of budgets and this reaction gives an idea of how the budget is accepted by the people and the market.

Like this, it has still many more uses, but the stock market index is a double edged sword. Because it is influenced by expectations of the future performance of the stocks, it leads to a self fulfilling prophecy. Suppose an investor thinks that the stock of the company is going to go down and this feeling prevails across the market then everyone would want to get out of the company’s stock. This will automatically lead to the stock prices crashing. This is a case of a single company’s stock, but what if a bearish feeling prevails? Then all stock prices will face tough times affecting the index. So just as the market index influences and affects decisions of individual traders, conversely the index itself is also affected by not just the market conditions as it is supposed to but also these players.

Another point to be noted is that the Stock Index can kindle “herd mentality”. Any downturn in the market would be reinforced by the collective action of the investors to hedge against any losses and get out of the market. This would further depress the market.

This is what is happening in markets across the world currently and can be taken as a good example. Even before adverse effects could be felt in reality by the various industries in India, the credit crunch and liquidity crisis in the United Stated of America affected the Indian stock markets, immediately resulting in the SENSEX and Nifty plummeting dangerously. (This happened not only in Indian stock markets but also in the European, Asian and Japanese markets).

This has happened due to the “perceived effects” of the investors and traders. Going more in detail, consider the SENSEX: Quite recently the SENSEX had lost a huge 2,527.82 points, or 19.36 per cent, within the time span of a mere 5 days. Friday, 10th October, 2008 saw the SENSEX fall to 10,239 points in early trade and close just above 10,500. But, the promising remarks of the Indian Finance Minister, P.Chidambaram, on Monday, 13th October, 2008 had an immediate positive effect with the SENSEX opening on a strong note and gaining over 780 points to regain the 11,000 level at close. And on Tuesday, it closed at 11,483 points.

So did the “market conditions” falter immensely but rectify at such lightening pace? Not likely. So then what happened?

Our economy is growing and the Gross Domestic Product (GDP) is predicted to be between a good 7.5% and 8.5% in this year, but then the markets plunged because of the perceptions of the investors and traders, and the “herd mentality” played its roles flawlessly, causing panic and mayhem in the markets, resulting in the indices shedding points massively.

Later the Finance Minister’s addressed the nation on Monday reassuring that the Indian economy is good and the root cause of the present uncertainty is liquidity and not any dramatic change in the fundamentals of the economy. He also stated that preventive steps were being taken to ensure the protection of the Indian economy and an additional Rs.600 billion was infused into the market (see http://www.indiainfoline.com/news/innernews.asp?storyId=81377&lmn=1 for further details). This created a welcome wave and the “herd mentality” played its part, but this time, positively, resulting in the stock market indices gaining points.

The indices are supposed to be indicators of the market condition; but the fact that they are also, to a great extent affected by and represent the general perceptions of the investors (noise element) more than the real news or events, can not be ignored.

Thus it can be seen that though the indices SENSEX and Nifty serve as a popular investor’s guide, it is riddled with imperfections which can also lead to confusion instead of providing aid and it is a double-edged sword indeed. So they do indicate the market conditions, but are also to a significant extent, representations of market sentiments (i.e., sentiments of the traders and investors).

And its true that….”It’s ironical that something as huge as a stock market which should be stable as it represents the economy of a nation, is actually extremely volatile since it is driven more by the sentiments of the people“