“The BSE Sensex has just recently broken the strong resistance at 17,000 levels and from 30 days moving average just hit another low and if you consider the macro environment, with the food bill adding another 2% to fiscal deficit and with current 4% growth rate coupled with 10%+ inflationary pressures not subsiding, there seems to be no end to the Rupee free fall… we are in for a free fall for the next few quarters. On company fundamentals too, look at advance tax collections…” went on and on, a research analyst advising me. Me and my gujju friend were dazed. I mean after a point in time it started sounding Greek to us. My friend, out of empathy simply waved his hand and blurted “Boss, don’t take tension… its election year. Once we get Narendrabhai as a PM with good majority, the sentiments will improve and all this problems will go away”.
Really… sentiments – one word against the epic numbers and empirical economic data. For a moment it felt like my gujju friend was one of those stupid illogical mass guy who believes strongly and gets swayed by hearsay. Someone who must be making investment decisions based on what he hears at the panwallah’s @ stock exchange or his equally messed up buddies in the Mumbai local trains… I mean come on… did he even realize the gravity and depth of the economic mess we were in, which his vague “market sentiments” could magically solve…
But then it had me thinking… my semi-literate gujju friend was more successful in making money from the markets than me – the one who followed the “MBA qualified research analyst” advice more often than not. And here is what I realized…
Its true… its sentiments – emotions, that are the base of economic drivers. Not financial numbers or economic statistics. The numbers are either potential plans (budgets, monetary policies, etc.) or postmortems (GDP stats, exchange rates, inflation rates, etc.) of events – both of which were dependent on actions of human beings. And the base of all human actions is emotions… sentiments.
Let me put it in a more ‘logical’ explanation. Any economist will be able to suggest the correlation between inflation, interest rates, fx rates, fiscal account deficits, etc. via a host of theories – purchasing power parity theorem, interest rate parity theorem, real interest vs nominal interest theory and so on. Some of them have a direct correlation (movements are in same direction – nations with lower inflation have lower interest rates) or inverse correlation (movements are in different directions – fall in rupee will increase our fiscal deficit). While correlations exists, the complexity arises from the fact that there are multiple other factors that determine the movement in each one of them i.e. all are interrelated… for example interest rates spurs inflation and it also affects fx rates – but fx rates also affect inflation.
What is however most interesting and unexplained is the elasticity of this correlation.
Elasticity is the measure of change in one variable vis a vis the change in other variable – or the beta for the financial wizards. We learnt this in our 11th standard economics class (who took commerce) by means of the elasticity of price theory (unless you left it in option 🙂 ). The concept is the same… just that I am applying it not for price and demand / supply but with other variables. What I mean is – sentiments is the major determinant of the elasticity – the change in say inflation vis a vis say the hankering of interest rates… or any other economically correlated variables.
I just realized that to some of you I must have started to sound not only Greek but also Latin and some other languages that I don’t even know the names of!
So chuck this ‘logical’ explanations. Back to the gujju style of deposition.
Take an example… RBI will increase interest rates to reduce inflation (increase in rates sucks up money from market, loan rates increase – borrowing reduces) – but that should also mean our fx rates should become better (more money flows in as investments to earn higher interest )… But bapu here is the catch as my gujju friend says… “sentiments bau kharab che… paisa kaun nakhe”… the sentiments are so bad that even the higher interest rates do not attract investments. And so the correlation fails… fx rates suddenly become inelastic to interest rates!
Outside this economic explanation, the base is still true… constructive production is the basis of all growth and economics. The driver or the fuel of human production is his emotions / sentiments. A negative human being will be less productive (logic applies at the mass level i.e. to society, market and nation as well). And once that happens, all economic theories either conflict or there is uncertainty on which one will work… and then economic numbers can only serve as postmortems – not the basis for action or change. Similar thing happens when a society is blinded by greed… it becomes illogical and economic theories assume rationality!
What make economics work are hence sentiments… they drive people’s decision to produce, make investments, stay invested, sell out, etc.… and sentiments can be of fear, helplessness, positivity, etc.… A simple example is – when S&P downgraded USA, logically their markets should have fallen, bond prices should have fallen i.e. money should have gone out. However on the contrary market sentiment was “wow, US will now be cheaper”, “chuck the ratings, we believe in the country’s ability to give us returns”, “what the heck, we have no choice to invest elsewhere”… and contrary to economic theories, investments in US stayed put or increased! Sentiments ruled over economics!
But who drives sentiments… It definitely has to be at a mass level to move the market… so it’s a crowd psychology thing… but what is it? Some news go viral and they die down… people forget and it does not have any lasting impact… some news have relevance but does not move enough people to make an impact… what creates that impact at the crowd level?
It is the mass leaders… when Gandhiji said “go swadeshi” – it caused great hardships to people and must probably have been a very inefficient economic model… but it appealed to the mass / crowd – if it would have happened today, government would ban foreign products / levy high excise / custom duties, lots of FMCG stocks would have crashed, FIIs would run away, FDI would stop, inflation would increase, etc. But if people would still sustain the movement – carry on the sentiments of belief; new Indian industries would probably (hopefully) spring up – bridge the gap between demand and supply, FIIs would see new investment opportunities, money would flow in and growth would return. But if people would cave in to the immediate fears or would not believe in the future possible success – i.e. new industries would not come in, foreign goods smuggled would be used and economy would never develop.
The difference then is of the crowd’s belief in the mass leader… in the sentiments that are created and maintained.
A mass leader – the crowd psychology expert than is the man to clear an economic mess – rather than an economist with no appeal…
The question however is – is there a true mass leader in which whole of India (or at least what can constitute mass enough to change ‘market’ sentiments) believes in… for definitely the economist is not the one. 2014 will tell…
Anyways… I have to call up my diamond market gujju friend – boss he seems to know more about the market then I do… and he says that in simple, couple of lines… “Hello Jignes…”
– Written on 31 August 2013.
Inside VG... 
Interesting article, Vaibhav!
What you write is true to a great extent. Sentiment is indeed a great force in driving the markets.
The question is: Should the market or economy be driven by sentiment?
Fear and greed are two emotions that all market participants are very well aware of. But it is a fact that the greatest fear coincides with the market bottom when one should actually be greedy and vice versa. As a result the masses more often than not end up losing money.
So it’s just not sentiment but the right sentiment at the right time which is needed to guide the economy to a path of sustained growth.
Sentiments themselves should be illumined by the light of reason and not remain blind.
That’s the job of a true leader.
He or she should not only be an expert in crowd psychology but also proficient in economics in order to channelise the sentiments of the masses towards desirable ends. Adolf Hitler was also a mass leader, but what fate did Germany meet under him?
Persons blinded by emotion do create an impact, but it’s short-lived.
Fundamentals determined by reason eventually take over.
There is an old adage on Wall Street:
“The market is a voting machine in the short term; but a weighing machine in the long run!”
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