Making sense of equity markets is a challenge: Look at RBI’s attempt

We have a range of theories, from the Efficient Market Hypothesis and Random Walk Theory to Modern Portfolio Theory, Capital Asset Pricing Model and the Arbitrage Pricing Theory, among others. Unfortunately, not one of these theories—some of which even won their theorists Nobel prizes—has stood the test of time. Markets, almost invariably, seem to have the last laugh. What can possibly explain the dizzying speed at which markets—whether in India or the US—have run up in the post-covid years, a period marked by a global slowdown in economic growth? Remember, India’s quarterly GDP contracted by nearly 24% in the first quarter of 2020-21, while the US was expected to tip into recession.

Sure, both economies have recorded sterling recoveries since, with the US appearing to defy attempts of the US Federal Reserve to slow it down. And India is expected to be one of the world’s fastest growing major economies, even as China struggles to regain its eminence as an engine of growth. But that alone does not quite explain why the S&P BSE Sensex was up 68% in covid year 2020-21 (it is up 25% in the period from 1 March 2022 to 26 April 2024). One can point to surplus liquidity, thanks to quantitative easing by central banks trying to tackle the pandemic’s fallout. Never mind that they have shifted to quantitative tightening, starting some two years ago. But can liquidity alone explain markets? Sadly, no. Which is why RBI’s new working paper is a welcome addition to the literature on this subject. 

It is true that “financial markets tend to react instantaneously with the release of new information and market prices reflect expectations about future economic and monetary developments." It is also true that market participants “typically extract information from the central bank’s monetary policy communication." Further, their reactions are coloured by whether policy actions were anticipated and incorporated into their decisions or not, with unanticipated changes more likely to impact markets. 

Using data on overnight indexed swaps, an interest-rate swap whose floating leg is linked to an overnight index, compounded every day over the payment period, the study concludes that “equity returns on policy announcement days are impacted only by the market’s expectations of the future monetary policy trajectory." Also, volatility in equity prices is affected by the surprise element of monetary policy and central bank messaging. Overall, equity markets are affected more by changes in market expectations of future monetary policy than by policy rate surprises.

Whether all this leaves us any wiser in our grasp of equity markets remains to be seen. For now, the party seems endless. Sure, we’ve seen corrections from time to time. But as Citigroup’s former CEO Chuck Prince once put it, “As long as the music is playing, you’ve got to get up and dance." Dance, many surely will. But don’t bet on an endless party.