Why a Rising Stock Market Doesn't Always Mean Better Business Performance

Prices and Profits Are Different Things

When the Nifty hits a new high, it is tempting to read it as a sign that Indian companies are doing better than ever. Sometimes they are. Often the link is much weaker than it looks.

An index is a price. A price reflects two things: what companies earn, and how much investors are willing to pay for each rupee of those earnings. Either one can move the index. Only the first is about business performance.

Splitting a Market Return Into Its Parts

Ignoring dividends, a market's price return comes from two sources:

(1 + Price return) = (1 + Earnings growth) × (1 + Change in P/E)

Illustrative example. An index starts the year at a P/E of 20. Here are three ways it could rise 15% in a year.

In Scenario A, the whole gain comes from better business results. In Scenario C, businesses earned exactly the same as the year before, and the entire gain came from investors paying more for the same profits.

The reverse also happens. If earnings grow 15% and the P/E falls from 20 to 17.4, the index ends the year flat. Companies did well; shareholders did not.

Reasons the Two Drift Apart

• Interest rates. When rates fall, future profits are worth more today, so investors pay a higher P/E. When rates rise, the opposite happens.
• Money flows. Steady inflows into equity funds can push multiples up for a time, independent of earnings.
• Expectations. A market can rise on hopes of future earnings. If those hopes are right, earnings later catch up. If not, the multiple falls back.
• Sentiment and risk appetite. Global events, elections and commodity shocks change how much risk investors want to take.
• One-offs at heavyweights. A large write-back or a one-time loss at one big company can move total index earnings, and the P/E, without any change in the wider business picture.
• Currency. For foreign investors, a weaker rupee cuts dollar returns. Their buying or selling can move prices for reasons that have little to do with Indian company profits.

The common thread is that the multiple reflects what investors expect and require, while earnings reflect what companies have delivered. The two answer different questions, so they do not have to move together.

The Index Is Not the Market

An index can also rise while most companies struggle. The Nifty 50 is weighted by free-float market cap, so a handful of large companies carry much of the weight. If three or four heavyweights rally, the index can climb even when most stocks fall.

This is called poor breadth. Two quick checks help:

• Advance-decline ratio. The number of stocks rising compared with the number falling.
• Equal-weight index. NSE publishes an equal-weight version of the Nifty 50. If it lags the main index badly, the rally is narrow.

A Worked Example Over Ten Years

Illustrative example. An index starts at a P/E of 18. Earnings grow 10% a year for five years, so profits rise about 61%. Over the same five years, investors grow more optimistic and the P/E rises to 24.

• Price return over five years: 1.61 × (24 ÷ 18) = about 2.15 times, a gain of about 115%.
• Earnings growth explains roughly 60% of that gain. The rest came from the higher multiple.

Now run the next five years. Earnings again grow 10% a year, another 61%. But the mood cools and the P/E drifts back to 18.

• Price return over the second five years: 1.61 × (18 ÷ 24) = about 1.21 times, a gain of only about 21%.

Across the full ten years, the P/E started and ended at 18, so the whole return came from earnings. But an investor who joined at the midpoint saw businesses grow just as fast as before and earned a fraction of the earlier return. Multiple changes cancel out over the full cycle. They do not cancel out for someone who arrives halfway.

The Market Is Not the Economy Either

There is a second gap: between listed companies and the wider economy. India's GDP includes farming, small businesses and government services that have no listed shares. The Nifty is weighted toward financial services, IT and a few other sectors. So strong GDP growth does not guarantee strong index earnings, and a strong index does not prove the broad economy is healthy.

Index earnings themselves can be concentrated. In some years, a single sector such as banks, oil and gas, or metals delivers most of the profit growth. When that sector's cycle turns, index earnings can stall even if most other companies are doing well.

Business and Market Over Longer Periods

Over a single year, changes in the multiple often dominate. Over ten or twenty years, they tend to even out, because a P/E cannot rise forever. Earnings growth, plus dividends, then explains most of the return.

That is why long-term investors focus on profits. Short-term price moves tell you about mood. Long-term returns tell you about businesses.

Habits for Reading a Market Move

1. Split every big move into earnings growth and change in the P/E.
2. Use the same earnings basis for start and end points.
3. Check breadth with the advance-decline ratio and the equal-weight index.
4. Note the interest rate backdrop when the multiple changes a lot.
5. Judge business performance from earnings, not from the index level.

The Reframe

A rising market tells you investors feel better. Rising earnings tell you businesses are doing better. They often happen together, but they are not the same thing, and confusing them is costly when the mood turns.