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Sensex: Hit New High. Is it Good News?

This is dialogue between Mr Curious(C) and Mr Omniscient (O) on recent high which Sensex has kissed.

C: Today Sensex hits the all time high. It touched as high as 40388.  Now, we can say that Indian Economy is going to grow with good pace now.

O: Perhaps, Yes or Perhaps No!! Can’t say till the time we get the real GDP growth number. But one thing for sure that perception good growth is building up. How right that perception is going to be, only time will tell.

C: Why?? Although I don’t know much about the Sensex, But Isn’t it reflects the real scenario of economic affairs?

O: Hmmm! To come on this conclusion you have to understand what is Sensex. What does it represent? Do you want to know that?

C: Sure!! Tell me about that.

O: Do you know what shares are?

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C: Yes! I think it is something whose price is defined by its supply and demand. If there is more demand of shares then its price will increase.

O: You are right. But it is not the answer of my question. In fact, price of everything is decided by its demand and supply. I am asking, what shares are?

C: I don’t know. Tell me.

O: Share is nothing but a representation of ownership. Let’s understand with simple example. Let’s say you and I open a shop together by contributing Rs 10000 each. In how many shares ownership of shop will be divided?  And what would be my share in that ownership.

C:  There would be two shares one is yours and another is mine. And off-course your share will be 50%.

O: In same manner company’s ownership is divided into particular number of shares. Let’s say in 1,00,000 shares. If you are having 100 shares of this company then you are having 0.1% ownership in the company. Further there are various types of shares, about which we will talk some other time.

C: But how can I buy that ownership?

O: You can buy that ownership from the current owner. It would be same way as if I sell my part of ownership in shop to somebody else and then that somebody else sells it to somebody else and so on. Although this buying and selling of shares are done on exchanges like Bombay Stock Exchange and National Stock Exchange etc.

C: Okie!! But tell me how the price of share moves? Why anyone would want to pay the higher price of the ownership?

O: Let’s understand with our shop example. Let’s assume that some person thinks that sales from our shop going to increase overtime. So that person will be ready to give more price for the shop compare to amount that we have invested.

C: Okie got it. Similarly, if someone thinks that company is going to perform better in future in term of generating profit, he will be ready to pay higher price for that share.

O: Exactly. And in same way if someone is pessimistic about the company performance he will either pay less for share or if he is already owning it he will ready to accept less money to get rid of that share.

C: Is this the only reason of so much fluctuation in share price?

O: No, not only that. There are lots of people who participates in buying and selling of shares. But ironically, there are very less people who know about the company fundamentals. Most of them follow the trend in market. In fact you can say that most of the people trade according to their perception about the direction of share price not about the company future performance.

C: So you want to say, there may be scenario where price of share may increased by good amount even if there is less chances of company growth.  But why does this happen?

O: Let’s understand it with our example of shop. Assume that we want to sell our shop and we ask for its bid. Let’s say someone spread news in market that govt. is having plan to build a highway in front of our shop. Because of this news people will start to speculate that overtime price of our shop will increase. Now they will start to bid higher to buy our shop. There are lots of other people who may not know anything about highway but they observe that people are ready to pay higher price for the shop. So they will assume there is something in the shop causing higher bidding. So they will also participate in buying the shop and it will going to have spiral effect. And this way price of our shop will increase due to misinformation and most importantly herd following.

C: Okie. So we can conclude higher price of our shop not necessary reflects that our shop going to generate more profit in future.

O: Exactly. It may produce but not necessary. Can you extend same logic on share price?

C: In same way we can say price of share may increase because of wrong perception about the company performance and its price may increase without any real change in company performance.

O: Yup! Similarly Sensex can increase or decrease without reflecting the real performance of economy.

C: You have not told me about Sensex.

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O: Oh!!! It is an index, short for Sensitive Index. It is indexed weighted average price of 30 companies listed on Bombay Stock Exchange (BSE). These companies are considered to represent our economy as a whole. This weighted average price is scaled with some base index value. The exact formula and other thing I will talk about later.  There are other indexes also, like Nifty50 of National Stock Exchange (NSE).  It is indexed weighted average price of 50 companies listed on NSE.

C: Got it, we can say that  that Sensex or Nifty 50 represents share price of important company for our economy so the perception of our economy growth.

O: Good!! Absolutely right. It only talks about the perception. And it is not surprising that many a times this perception is proved wrong. In fact, do you know that Sensex has touch its previous high of 40310 during June month of 2019. And do you know at what rate our GDP increase during that time?

C: No. Was it really slow?

O: It grew only by 5%. This growth was slowest during last 6 six years but Sensex was lifetime high at that time.

C: So, does that mean Sensex have no relation with real economy growth?

O: No, it is not always true. As already said, it all about perception. If perception is right it will reflect true performance of economy.

C: Hope, this time perception is going to be right and our economy will do well.

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